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REPORT

2016-17

BANKING, FINANCIAL SERVICES AND


INSURANCE

Banking , Financial Services and Insurance

Table of Contents
BANKING

WHAT IS A BANK?

HOW DOES A BANK FUNCTION?

WHAT IS THE ROLE OF THE BANKS?

What are the benefits of Intermediation?

FUNCTIONS OF A BANK

10

STRUCTURE OF INDIAN BANKING SYSTEM

10

COMMERCIAL BANKS

11

SBI and its associates

13

Nationalized Public Banks

13

Private Sector Banks

14

Regional Rural Banks

14

PAYMENT BANKS

16

Characteristics of Payment Banks:

16

Rules for Payment Banks

16

Current scenario

17

SMALL BANKS

17

SPECIALIZED BANKS

18

INSTITUTIONAL BANKS

18

NBFCS

18
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Banking , Financial Services and Insurance


CO-OPERATIVE BANKS

19

RESERVE BANK OF INDIA

19

CASH RESERVE RATIO (CRR)

20

NDTL (Net Demand and Time Liabilities)

20

STATUTORY LIQUIDITY RATIO (SLR)

20

REPO RATE

21

REVERSE REPO RATE

21

LAF FUNCTIONING

21

MARGINAL STANDING FACILITY

22

SHIFT OF BASE RATE TO MARGINAL COST OF LENDING RATE

23

RBIs key guidelines on MCLR

23

How MCLR Works? (Example)

24

OPEN MARKET OPERATIONS (OMO)

25

BASEL

25

Basel I Norms

25

Basel II Norms

25

Changes proposed in BASEL III over BASEL II norms:

26

Implementation of BASEL III in India

28

Impact of BASEL III on Indian Banks

28

MANAGING FINANCIAL RISKS FOR BANKS-ASSET LIABILITY MANAGEMENT

29

OTHER FINANCIAL RISKS ASSOCIATED WITH BANKS

30
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Banking , Financial Services and Insurance


Interest Rate Risk

30

Credit Risk

31

MONEY MARKETS

32

Money Markets in India

32

Commercial Papers (CP)

33

Certificate of Deposits (CDs)

33

Collateralized Borrowing and Lending Obligation (CBLO)

33

Mumbai Inter-Bank Offered Rate (MIBOR)

33

ROLE OF MONEY MARKETS IN MONETARY POLICY TRANSMISSION

34

Open Market Operations

34

Cash Reserve Requirement

34

GOVERNMENT FINANCES

35

Fiscal deficit

35

Current Account Deficit

35

MAJOR BANKING SECTOR REFORMS SINCE 1991

36

RECENT DEVELOPMENTS

37

The Insolvency and Bankruptcy code, 2016

37

India Post Payments Bank Incorporated

37

Unified Payments Interface:

38

Scheme for Sustainable Structuring of Stressed Assets

38

Peer to Peer lending:

39

Asset Quality Review

39

Masala Bonds

40

Banking , Financial Services and Insurance


RBI prescribes norms for enhancing credit to large borrowers

41

Loan to women SHGs at 7%

41

Bharat Bill Payment System

42

Monetary Policy Committee

42

The Union Budget 2016-17

43

INTERNATIONAL UPDATES:

44

Negative yield and Quantitative easing in Japan

44

US rate hike Just a matter of when

44

Bank of England cuts rate:

45

RECENT MERGERS AND ACQUISITIONS OF STAKES IN THE BANKING SECTOR:

46

State Bank of India merger with its associates and Bhartiya Mahila Bank.

46

IDFC Bank buys Tamil Nadu-based Grama Vidiyal Microfinance

46

Canada pension fund buys stake in Kotak Mahindra Bank

47

Kotak Mahindra Bank buys 19.9 per cent stake in Airtel M Commerce Services

47

DECLINING ASSET QUALITY OF BANKS

48

Profitability

49

ASSET RECONSTRUCTION COMPANY

50

How do ARCs make money?

50

Problem of Capitilsation.

50

RECENT TRENDS (ANALYSIS OF Q1FY 2017)

51

SECTOR WISE BANK CREDIT IN 2015-16

53

PRIORITY SECTOR LENDING:

54

Banking , Financial Services and Insurance


ANALYSIS OF A BANKING STOCK:

56

How to analyse a Bank? How to pick up a correct Banking stock ?

56

The Balance Sheet of a bank

56

Capital and Liabilities

56
st

Common Size Balance sheet for SBI and YES Bank as on 31 March 2016

58

Income Statement

58

Common Size Profit and Loss for SBI and YES Bank

59

Specific Ratios for a Bank:

59

9. Classification of Assets

61

Financial Information for SBI and Yes Bank

63

Analyzing a Bank stock

63

What the bank actually does?

64

Price:

65

Earning Power:

65

The amount of risk it's taking to achieve that earnings power

66

INSURANCE:

67

Classification:

67

Bank Insurance Model or Bancassurance

67

Overview of the insurance sector in India

68

SPECIALISED INSURERS

69

Stand Alone Health Insurance Companies

69

Performance of the sector:

69

Trends in the sector

70

Investments

71

Banking , Financial Services and Insurance


Government Initiatives

72

Road Ahead

73

NON-BANKING FINANCIAL COMPANIES (NBFC)

74

Factors contributing to the growth of NBFCs:

74

The NBFC sector in India

74

RBI agenda for 2016-17

76

Introduction of account aggregator NBFCs

76

Liberalizing foreign investment in the NBFC sector:

76

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, (SARFAESI
Act)77
Simplification of the NBFC application process

77

Developments:

77

MUTUAL FUNDS

79

Mutual Fund Industry in India

80

OTHER FINANCIAL SERVICES

80

Intermediary Advisory Services

80

Private Equity

80

Conglomerates

80

PSB VS PRIVATE BANKS

81

SECTOR OUTLOOK:

83

Retail segment to be the key driver for credit growth in 2016-17

85

NATIONAL HOUSING BANK:

87

HOUSING FINANCE COMPANY (HFCS)

87
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Banking , Financial Services and Insurance


Difference between bank and HFC:

88

Benefits of HFCs over Banks

89

Benefits of Banks over HFCs

89

MICRO-BANKING

90

COMPANY COVERAGE: BHARAT FINANCIAL INCLUSION LIMITED

94

Banking , Financial Services and Insurance

Banking
The banking sector has a very high positive correlation with majority of the sectors of the Indian
economy, as it fuels them with the necessary credit they require to fund both their Capital and
working capital expenditures. Given the fact that the banking sector propels growth in the
economy; its importance is of great extent. Thus Reserve Bank of India, the regulatory body
exercises stringent norms to exercise control on the banking sector to protect the economy from
any crisis. A strong and viable banking industry is extremely necessary for economic progress
while a weak banking sector is a cause for problems in the economy. Banking is used for policy
transmissions by controlling the money supply for sustaining economic growth.

Correlation of Banks with other sectors


1

0.5

0
Auto

Energy

FMCG

IT

Media

Metal

Pharma

Realty

Source: www.nseindia.com

What is a bank?
The term bank is either derived from the Old Italian word banca or from a French word
banque both mean a Bench or money exchange table. It is a financial institution which is
authorized by the regulators of the regulatory bodies to accept deposit and lend money, in order
to earn differential interest between the interest paid and earned. Today banks provide various
other financial services like insurance, mutual fund investment in order to reduce the dependence
on interest income.

How does a Bank Function?


Banks play an important role in the financial system and the economy. As a key component of
the financial system, banks allocate funds from savers to borrowers in an efficient manner. They
provide specialized financial services, which reduce the cost of obtaining information about both
savings and borrowing opportunities. These financial services help to make the overall economy
more efficient.
A portion of money thus received by the bank is kept aside for regulatory requirements. The
remaining money is given to borrowers and used to make investments. The bank charges interest
on these borrowings and investments. The difference in the interest received and the interest paid
is the income for the bank, which the bank uses to pay for its expenses and any amount left is
profit for the bank. Banks take in money from a large number of depositors and lend money to a

Banking , Financial Services and Insurance


large number of borrowers. This creates a flow of money in the banking system while also
spreading the risks associated with lending to a large number of borrowers. Banks charge money
for acting as intermediary in managing this flow of money and any risks they are undertaking by
the giving of loans.

What is the role of the banks?


Banks play the role of financial intermediation in the economy. For any economic activity to
happen funds (money) are a must and funds are a scarce resource for the organization intending
to involve in the activity. Here banks play a crucial role in terms of channeling the funds from
the source to the point of use. Banks act as an intermediate between those who have funds
without knowing where to deploy them and those who are in need of the funds. Banks lets
demand for money meet supply for money. In other words, it provides a meeting point for both
borrowers and lenders of money.
What are the benefits of Intermediation?
1. Intermediation smoothens the borrowing and lending process in an economy. It ensures
efficient allocation and profitable use of the capital by channeling and bridging the gap
appropriately between the sources of funds and the users of funds in turn helping the
economic growth. Example, if company A has a profitable project for INR 1 crore and it
does not have its own funds to finance this project. On the other hand many individuals have
a surplus INR10,000/- of without any idea of investing in profitable investment opportunity.
Here Intermediation helps by channeling many of the INR 10,000/- surpluses to fund INR 1
crore need.
2. Pooling of funds bring economy of scale and reduces cost. Which of the two options would
cost less to administer? One, 10 million portfolio or ten 1 million portfolio and obviously
the answer is one 10million portfolio. Here Intermediation helps to manage and reduce cost
of managing funds by pooling. While doing the role of intermediation banks would come
out with multiple loans and deposits products to meet the risk & rewards requirement of
each individual.

Besides this intermediation function, banks also play a major role in the payment process like
cheque processing and card payments. Banks also offers other financial services like Cash
management services, Opening of Letter of credit, Locker facilities.

Banking , Financial Services and Insurance

Functions of a Bank

Functions of Banks

Primary Functions

Secondary Functions

Accepting Deposits

Granting loans and


Advances

Agency Functions

Saving Deposits,
Current deposits,
Fixed Deposits,
Recurring Deposits

Loans,Cash Credit, Bank


Overdraft ,Discounting BIlls

Funds Transfers,Cheque
collection,Periodic
Payments/Collections,
Portfolio Management

Utility Functions

Issue of Drafts,Locker
facilities,Dealing in Foreign
Exchange,Project Reports

Structure of Indian banking system

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Commercial banks
A commercial bank may be defined as a financial institution that provides services, such as
accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment
products like savings accounts and certificates of deposit. In addition to giving short-term loans,
commercial banks also give medium-term and long-term loans to business enterprises.
Commercial banks are of the following seven types:

Nationalized banks
SBI and associates
Regional rural banks
Private sector banks
Foreign banks
Payment banks
Small Banks

Public sector banks include SBI & its associates, nationalized banks and Regional Rural banks.
Public sector banks (accounted for the largest share of 75.9 per cent in aggregate deposits and
73.9 per cent in gross bank credit followed by private sector banks (19.7 per cent and 20.8 per
cent, respectively) as on March 31, 2015. The complete data is available with a lag. The
Distribution of total deposits, total credit and bank branches as per 31 st March, and 2015 is given
below:-

Total Deposits( INR 89221 Billion)

20%

22%

SBI & It's Associates


Nationalised Banks

3%

Foreign Banks

4%

Regional Rural Banks


Private Banks
51%

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Banking , Financial Services and Insurance

Total Credit(INR 68785 Billion)

21%

21%

SBI & It's Associates


Nationalised Banks

3%

Foreign Banks

5%

Regional Rural Banks


Private Banks
50%

Branches(130482)

16%

18%

SBI & It's Associates


Nationalised Banks

15%

Foreign Banks
Regional Rural Banks

0%

51%

Private Banks

Source: RBI statistical Returns 10th March 2016

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Banking , Financial Services and Insurance


SBI and its associates
SBI has five associate banks; all use the State Bank of India logo, which is a blue circle, and all
use the State Bank of name, followed by the regional headquarters' name:

State Bank of Bikaner & Jaipur


State Bank of Hyderabad
State Bank of Mysore
State Bank of Patiala
State Bank of Travancore

SBI and its associates are spread out across India with a presence of close to 23,947 branches,
total deposits amounting to INR 19,55,217 Cr. and advances amounting to INR 148,08,718 as on
31st March, 2015. SBI can be considered as the only Indian bank whose guarantee is accepted by
most of the Export Credit Agencies globally without seeking confirmation. The major promoters
of SBI include Government of India with a 60.18%.
Nationalized Public Banks
Banks other than SBI and associates which have more than 51% stake held by the Government
are included in this category. Currently, along with IDBI 19 such banks exist where Government
is the majority stakeholder. Nationalized Banks include - Allahabad Bank, Andhra Bank, Bank
of Baroda, Bank of India, Bank of Maharashtra, Canara Bank, Central Bank of India,
Corporation Bank, Dena Bank, Indian Bank, Indian Overseas Bank, Oriental Bank of
Commerce, Punjab & Sind Bank, Punjab National Bank, Syndicate Bank, UCO Bank, Union
Bank of India, United Bank of India and Vijaya Bank. These banks are spread over 65,764
branches with deposits and advances amounting to around INR 45,47,283.63 Cr. and INR
34,47,439.27 Cr as on 31st March, 2015 respectively. Top two banks in terms of size in this
category are Punjab National Bank and Bank of Baroda.
Many of these banks were private banks earlier but were nationalized by the government in
pursuance with its socialist objectives. The primary objective of nationalized banks is to meet the
social requirements of providing financial inclusion and services to the weaker sections of the
society.

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Banking , Financial Services and Insurance


Private Sector Banks
These are the banks in which majority of share capital is held by private individuals. These banks
can be classified into two categories:
Old Private Sector Banks
The private banks, which existed and were not nationalized at the time of bank nationalization
that took place during 1969 and 1980, are known to be the old private sector banks. These were
not nationalized because of their small size and regional focus. Some of the main old private
sector banks are Catholic Syrian Bank, Federal Bank, ING Vysya Bank(Now Kotak Mahindra
Bank), Dhanlaxmi Bank and Karnataka Bank.
New Private Sector Banks
These are the Private Banks which were set up post liberalization, with the introduction of
reforms in the banking sector. The entry of new private sector banks was permitted after the
Banking Regulation Act was amended. Banking licenses were given in two phases. In the first
phase, in 1994 banks like HDFC and ICICI were given licenses. In the next round of bank
licenses, in 2004 banks like Yes Bank were set up. In 2014, Bandhan and IDFC Ltd. were
granted license by RBI. Bandhan Bank has started its operations on 23rd August, 2015. The
prominent new private sector banks are HDFC Bank, ICICI Bank, Axis Bank, Yes Bank and
Kotak Mahindra Bank.
These banks are spread over 20,434 branches as on 31st March, 2015. Respectively and Most of
these banks have concentrated in metropolitan, urban and semi urban areas with around only
20% of branches of these banks in the rural area as on 31st March, 2015.

Regional Rural Banks


Regional Rural Banks are local level banking organizations operating in different States of India.
They have been created with a view to serve primarily the rural areas of India with basic banking
and financial services. The main purpose of RRB's is to mobilize financial resources from rural /
semi-urban areas and grant loans and advances mostly to small and marginal farmers,
agricultural labourers and rural artisans. The area of operation of RRBs is limited to the area as
notified by Government of India covering one or more districts in the State.
Recent Regulations & Supervisions by RBI
RRBs were allowed to extend internet banking facility to their customers: Only Profitable
RRBs with minimum Rs 100 crore net worth and better asset quality will be allowed to offer this
service. Banks with capital adequacy ratio over 10% will be allowed to introduce the online
transaction services. They need to have their gross NPA ratio less than 7% and their net NPA
should not exceed 3%. The bank should have made a net profit in the immediate preceding
financial year and overall, should have made net profit at least in three out of the preceding four
financial years. Weak banks will be allowed to offer internet services (view only) without online
transaction facilities.
Priority sector lending: Guidelines for RRBs were revised by setting for them an overall target
of 75 per cent of the total
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Banking , Financial Services and Insurance


Outstanding loan: 75 per cent of RRBs outstanding advances should be for PSL, which also
include loans to micro and small enterprises, weaker sections, housing and education, against 60
per cent now. The PSL norms have been revised considering the growing significance of RRBs
in pursuit of financial inclusion agenda.
Prescription of minimum CRAR of 9 per cent for RRBs: After the amalgamation and
recapitalization of weak RRBs, a minimum CRAR of 9 per cent on an on-going basis was
prescribed for all RRBs with effect from March 31, 2014.
Guidelines for classification and valuation of investments by RRBs: RRBs have been advised
to introduce mark to market (MTM) norms with respect to SLR securities beyond 24.5 per cent
of DTLs held in the held to maturity (HTM) category with effect from April 1, 2014 and to
classify their investments into three categories: held to maturity (HTM), held for trading (HFT)
and available for sale (AFS).
Foreign Banks
Foreign banks have their registered and head offices in foreign countries but operate their
branches in India. The RBI permits these banks to operate either through branches; or through
wholly-owned subsidiaries. The primary activity of most foreign banks in India has been in the
corporate segment. In addition to the entry of the new private banks in the mid-90s, the increased
presence of foreign banks in India has also contributed to boosting competition in the banking
sector.
As of 31st March 2015, There were a total of 332 branches of foreign banks in India with
Standard Chartered Bank (100) having the highest number of branches.
A foreign bank can deploy a maximum of four expatriates for each branch opened in India and
not more than six
Expatriates for their head office functions. Till recently, the 40% priority sector loan norm was
applicable to local banks; for foreign banks it was 32%. Even within this, 12% could have been
given as export credit. However both these relaxations are only applicable to foreign banks with
less than 20 branches. For foreign banks greater than 20 branches: only export credit to the
priority sector will be treated as priority sector credit.

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Payment Banks
The Reserve Bank of India (RBI) on 19th August, 2015 gave in-principle approval to 11 entities
to open payments banks that will widen the reach of banking services and push the governments
goal of financial inclusion.
Characteristics of Payment Banks:

They cant offer loans but can raise deposits of up to Rs. 1 lakh, and pay interest on these
balances just like a savings bank account does.

They can enable transfers and remittances through a mobile phone.

They can offer services such as automatic payments of bills, and purchases in cashless,
chequeless transactions through a phone.

They can issue debit cards and ATM cards usable on ATM networks of all banks.

They can transfer money directly to bank accounts at nearly no cost being a part of the
gateway that connects banks.

They can provide forex cards to travelers, usable again as a debit or ATM card all over
India.

They can offer forex services at charges lower than banks.

They can also offer card acceptance mechanisms to third parties such as the Apple Pay.

Rules for Payment Banks

The rules governing payments banks have been specified by RBI and are as follow:Provide payment and remittance services via internet, branches, business correspondents
(BC) and mobile banking
Cannot offer direct credit facilities, but can act as a BC for another bank
Cannot accept Fixed Deposits
Have to maintain the required Cash Reserve Ratio (CRR) as specified by RBI
Need to invest at least 75% of deposits collected in securities (having tenor of up to one
year) eligible for statutory liquidity ratio (SLR) investments
Hold up to 25% in current and time deposits with other scheduled commercial banks
Must have a minimum capital of Rs.1 billion and net worth of Rs.1 billion at all times
Maintain minimum capital adequacy ratio of 15% of risk-weighted assets
The total outside liabilities should not exceed 33.33 times the net worth

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Promoters should hold at least 40% of paid-up equity capital for first five years once the
bank becomes operational
Foreign shareholding limit will be at par with private banks currently set at 74%
Diversified ownership and listing mandatory, within three years after the banks net worth
reaches Rs.500 crore and it becomes systemically important
The leverage ratio requirements have also been eased to 3% from the earlier proposed 5%

Current scenario
Of the 11 companies that were given in-principle nod by the Reserve Bank of India (RBI) to set
up payments banks in August, 2015, three -- Tech Mahindra, Cholamandalam Finance and Dilip
Shanghvi-IDFC Bank-Telenor JV, have already dropped out. This leaves only eight applicants in
the frayIndia Post, Airtel Money, Reliance Industries, Vijay Shekhar Sharma, Aditya Birla
Nuvo, Vodafone MPesa, Fino PayTech and NSDL.
Unlike regular banks, which typically do business for interest margins from the lending business
using deposit money, these entities do not have the liberty to lend. Payments bank has to
primarily survive on fee-income since 75 percent of their deposits have to be mandatorily
invested in government bonds with maturity up to a year.
To get deposits, competing with regular banks which offer up to 7 percent return on their savings
deposits, payments banks will have to offer aggressive rates. However, a majority of the amount
in government bonds for a maximum 7.45 percent-8 percent (the approximate yield on one year
paper), would mean no real business. The cost to set up and run operations far outweighs the
benefits.
The first payments bank license was granted to Airtel Payment Bank Ltd. in April 2016.
It offers mobile money services under the brand name Airtel Money, will convert the existing
pre-paid payment instrument (PPI) licence into a payments bank license, as per the guidelines
prescribed by the central bank. It has formed a joint venture with Kotak Mahindra Bank Ltd,
which has come in as an investor.

Small Banks
Reserve Bank of India has granted in-principle licencefor small finance banks to ten entities.
The name of the applicants that have been granted the licence include- Au Financiers, Capital
Local Area Bank , Disha Microfin, Equitas Holdings, ESAF Microfinance and Investments,
Janalakshmi Financial Services, RGVN (North East) Microfinance, Suryoday Micro Finance,
Ujjivan Financial Services and Utkarsh Micro Finance.The in-principle approval granted
by RBI will be valid for a period of 18 months.
Small Finance Banks will be similar to the existing commercial lenders and will undertake basic
banking activities of accepting deposits and lending to unserved and under-served sections. The
maximum loan size and investment limit exposure to single and group obligators cannot be more
than 10 per cent and 15 per cent of its capital funds, respectively.

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Apart from this, at least 50 per cent of their loan portfolio has to include loans and advances of
up to Rs 25 lakh, as per RBI regulations. 72 applicants have applied for Small Finance Banks.
The regulator had also said that small banks can convert themselves into universal banks, though
the transition would not be automatic and will depend on the regulators approval.
Guidelines

No Geographical restriction on the operation of the small banks


75% of loans must be to the so-called priority sector which includes agriculture and small
businesses
50% of the loan portfolio should be loans and advances up to Rs.25 Lakh
Individuals with 10 years of experience in banking and finance and companies and societies
controlled by Indian residents together with NBFCs, micro finance institutions and local area
banks (LABs) can opt for conversion into small banks
The minimum paid-up equity capital for small banks is Rs.100 crore
These banks will have to maintain the mandatory CRR and SLR requirements
Promoters of small banks must own 40% equity in the new venture initially, but will need to
bring this down to 26% within 12 years from the date of commencement of business
Foreign shareholding in these banks has been capped at 74%

Specialized Banks
There are some banks, which cater to the requirements and provide overall support for setting up
business in specific areas of activity. EXIM Bank, SIDBI (Small Industrial Development Bank
of India) and NABARD (National Bank for Agricultural and Rural Development) are examples
of such banks. They engage themselves in some specific area or activity and thus, are called
specialized banks.

Institutional Banks
These are banks which were set up by the Government with the purpose of catering to the needs
of the industry. These banks provide low cost funds to borrowers. Examples include institutions
like IFCI and the State Financial Corporations (SFCs).

NBFCs
Non-Banking Financial institutions or NBFCs are those financial institutions which provide
financial services without meeting the general definition of bank. These institutions do not hold a
banking license. Despite this, they provide a wide range of financial services and are regulated
by the RBI. NBFCs offer most of the services offered by the conventional banking system
including loans and credit facilities, education funding, retirement plans, wealth management and
trading in money markets. NBFCs can accept public deposits but they cannot accept demand
deposits. NBFCs do not form a part of the payment and settlement system and hence cannot
issue cheques drawn on self. NBFCs are discussed in more detail later in the report.
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Co-operative banks
A co-operative bank is a financial entity which belongs to its members, who are at the same time
the owners and the customers of their bank. Co-operative banks are often created by persons
belonging to the same local or professional community or sharing a common interest. They
generally provide their members with a wide range of banking services (loans, deposits, banking
accounts, etc.). Formed under the Co-operative Societies Act, Co-operative banks are run on not
for profit basis.

Reserve Bank of India


The Reserve Bank of India (RBI), which commenced operations on April 1, 1935, is at the centre
of Indias financial system. Hence it is called the Central Bank. It has a fundamental
commitment of maintaining the nations monetary and financial stability. It started as a private
shareholders bank but was nationalized in 1949, under the Reserve Bank (Transfer of Public
Ownership) Act, 1948. RBI is banker to the Central Government, State Governments and Banks.
Key functions of RBI include:

Monetary policy formulation


Supervision of Banking companies, Non-banking Finance companies and Financial Sector,
Primary Dealers and Credit Information Bureaus
Regulation of money market, government securities market, foreign exchange market and
derivatives linked to these markets
Management of foreign currency reserves of the country and its current and capital account
Issue and management of currency
Oversight of payment and settlement systems
Development of banking sector
Research and statistics

While RBI performs these functions, the actual banking needs of individuals, companies and
other establishments are majorly met by banking institutions (called commercial banks) and
nonbanking finance companies that are regulated by RBI. RBI exercises its supervisory powers
over banks under the Banking Companies Act, 1949, which later became Banking Regulation
Act, 1949.

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Cash Reserve Ratio (CRR)


CRR is the cash that banks need to keep with the RBI as a certain percentage of their net demand
and time liabilities. Banks are not allowed any interest on this cash. This cash requirement is
calculated on a fortnightly basis. Banks come up with their NDTL on a fortnight basis and this
value is used to compute the cash required to be kept as CRR in RBI. To maintain flexibility,
banks are allowed to choose an optimum strategy of holding reserves depending upon their intrafortnight cash flows. All banks are required to maintain minimum CRR balances up to 95 per
cent of the average daily required reserves for a reporting fortnight on all days of the fortnight.
Banks failing to comply with the CRR requirement are penalized with a rate of interest which is
excess of three per cent from the bank rate on the shortfall amount and if this shortfall persists,
penalty will be excess of five per cent from the bank rate. Earlier interest was paid on cash kept
with RBI for CRR, but the rate was very high causing CRR to become unproductive. As a result
the interest was gradually reduced and was finally abolished in 2007. Some bankers have also
demanded that the CRR be abolished but it has been refused by the RBI.
Currently RBI has kept the CRR at 4% of NDTL. As an illustration, if a bank has INR 100 Cr.
worth of NDTL, it is required to keep INR 4 Cr. kept at RBI account as part of its CRR
requirement.

RBI uses this tool as a means to remove extra liquidity from the market or inject liquidity in the
market. By increasing the CRR, banks are forced to keep more cash at RBI, thus reducing the
amount they have to lend, thereby creating a shortage of money supplied in the economy. This
increases the cost of capital and thus the interest rates charge by the bank for credit. Similarly, by
decreasing the CRR, RBI aims to reduce the overall interest rates in the economy. CRR is an
important tool used by RBI to check inflation as inflation is directly linked to the interest rates
prevalent in the economy.

NDTL (Net Demand and Time Liabilities)


Demand Liabilities
Demand Liabilities of a bank are liabilities which are payable on demand. These include current
deposits, demand liability portion of savings deposits, balances in overdue fixed deposits, etc.
Time Liabilities
Time Liabilities of a bank are those which are payable otherwise than on demand. These include
fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of
savings bank deposits, etc.

Statutory Liquidity Ratio (SLR)


Similar to CRR, SLR is the amount that banks are required to maintain in the form of securities
or assets specified by the RBI. These assets include cash, gold, treasury bills of the government
of India, government securities, state development loans, etc.

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SLR is defined as a percentage of their NDTL. Maximum permissible SLR is 40% of NDTL.
Penalty on shortfall in this reserve requirement is also same as that in case of CRR. Currently
RBI has kept the SLR at 21% of NDTL. As an illustration, if a bank has INR 100 Cr. worth of
NDTL, it is required to keep at least INR 21 Cr. in assets mentioned above or specified by RBI.
An increase in SLR would reduce the amount of money that banks can pump into the economy
and vice versa. However the effect of change in SLR is lesser compared to that witnessed with
the change in CRR.

Repo Rate
When banks have any shortage of funds, they can borrow it from RBI or from other banks. The
rate at which the RBI lends money to commercial banks is called repo rate, an acronym for
repurchase agreement. Repo is a collateralized lending i.e. the banks which borrow money from
RBI have to sell securities, usually bonds to RBI with an agreement to repurchase the same at a
predetermined rate and date. In this way, for the lender of the cash (RBI), the securities sold by
the borrower are the collateral against default risk and for the borrower of cash (usually
commercial banks), cash received from the lender is the collateral. A reduction in the repo rate
will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI
becomes more expensive.
As an illustration, if a bank has INR 100, CRR and SLR requirement would mandate the bank to
park INR 4 with RBI as CRR and it has to have RBI approved government securities worth INR
21. Now the bank can lend the remaining INR 75. Let us say in this case, out of the remaining
INR 75, bank had extra INR 1 invested in the form of government securities and it is in need of
extra capital to fund its immediate credit requirement. The bank can then enter into repurchase
agreement with RBI; RBI would pump it with cash (in case of overnight repo around INR 0.25)
by purchasing government securities worth that much money.

Reverse Repo Rate


Reverse repo rate is the rate at which the RBI borrows money from commercial banks. Banks are
always happy to lend money to the RBI since their money is in safe hands with a good interest.
An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn
higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money
out of the banking system. According to norms laid down by RBI, the reverse repo rate is less
than the repo rate by 50bps.

LAF functioning
Currently RBI has kept the repo rate at 6.5 % which makes the reverse repo rate to be 6%. RBI
has restricted lending undertaken under this facility to be 1% of NDTL for a particular bank.
Overnight repo provided under LAF is only 0.25% of NDTL for a particular bank, whereas term
(for 7-day and 14-day maturity) repos provided under LAF is 0.75% of NDTL of that bank. The
primary objective of the increased reliance on term repos is to improve the transmission of policy
impulses across the interest rate spectrum. This will mean that banks will have to borrow more
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than they think they need and then use the call money market to offload excess liquidity (or
borrow even more, should they have borrowed less). The interbank call money market rate then
gives the RBI a better indicator of liquidity. This interbank money market rate should be close
enough to the repo rate, so that banks would rather borrow from each other than the RBI. This is
a change in the liquidity system, and RBI has attempted to move actively from now (lender of
first resort) to an actual lender of last resort.

Marginal Standing Facility


This facility was constituted by RBI to provide banks with overnight credit over and above the
limit of LAF. Similar to LAF, under this facility as well, banks borrow and lend money by
selling and buying excess SLR assets. The banks can borrow a maximum of 2% of NDTL from
this facility against their SLR holdings. Within this facility banks are allowed to borrow even if
they do not meet the SLR requirement, which means that even if they do not have excess SLR
funds, they can borrow up to 2% of their NDTL. MSF rate is always 50 basis points above the
repo rate, which makes the current rate as 7%.
The table below aims at capturing how the banks can use the LAF and MSF facility.
NDTL
SLR Requirement

100
21

SLR securities

Excess
SLR

Overnight
borrowing
through
Repo

Overnight
Borrowing Residual
throughSLR
MSF

24
23.5
23.25

3
2.5
2.25

0.25
0.25
0.25

2
2
2

21.75
21.25
21

22.25

1.25

0.25

20

21.25

0.25

0.25

19

21
20

0
-1

2
-

19

Comments

MSF limit of 2%
MSF limit of 2%
MSF limit of 2%
Reduces effective SLR by
1%
Reduces effective SLR by
2%
Reduces effective SLR by
2%
Compliance Issue

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Shift of Base rate to Marginal Cost of Lending Rate


The main components of base rate system are:

Cost of funds
Operating expenses to run the bank.
Minimum Rate of return i.e. margin or profit
Cost of maintaining CRR

As it can be observed, the banks do not consider repo rate in their calculations. They primarily
depend on the composition of CASA (Current accounts & Savings Accounts) and deposits to
calculate the lending rate. Most of the banks are currently following average cost of fund
calculation. So, any cut or increase in rates (especially key rate like Repo Rate) by the RBI is not
getting transmitted to the bank customers immediately.
As per the RBIs new guidelines, it is mandatory for the banks to consider the repo rate while
calculating MCLR with effective from 1st April, 2016. The new method Marginal Cost of
funds based Lending Rate (MCLR) will replace the present base rate system.
The main components of MCLR calculation are;

Operating Expenses
Cost of maintaining CRR
Marginal Cost of funds
After considering interest rates offered on savings / current / term deposit
accounts.
Based on cost of borrowings i.e., short term borrowing rate which is repo rate &
also on long-term borrowing rates.
Return on Net-worth
Tenor Premium (an additional slab of interest over the base rate, based on the loan
tenure & commitments)

The main differences between the two calculations are i) marginal cost of funds & ii) tenor
premium. The marginal cost of funds will have high weightage while calculating MCLR. So, any
change in key rates (increase or decrease) like repo rate brings changes in marginal cost of
funds and hence the MCLR should also be changed by the banks immediately.
RBIs key guidelines on MCLR

All loans sanctioned and credit limits renewed w.e.f April 1, 2016 will be priced based on
the Marginal Cost of Funds based Lending Rate.
MCLR will be a tenor-based benchmark instead of a single rate. This allows banks to
more efficiently price loans at different tenors based on different MCLRs, according to
their funding composition and strategies.

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Banks have to review and publish their MCLR of different maturities every month on a
pre-announced date.
The final lending rates offered by the banks will be based on by adding the spread to the
MCLR rate.
Banks may specify interest reset dates on their floating rate loans. They will have the
option to offer loans with reset dates linked either to the date of sanction of the
loan/credit limits or to the date of review of MCLR.
The periodicity of reset can be one year or lower.
The MCLR prevailing on the day the loan is sanctioned will be applicable till the next
reset date (irrespective of changes in the benchmark rates during the interim period). For
example, if the bank has given a one-year reset period in your loan agreement, and the
base rate at the beginning of the year is say 10%, even if the interest rate comes to 9% in
the middle of the year, the customer will continue at 10% till the reset date. Same will be
the case even if the interest rate increases above 10%.
Existing borrowers with loans linked to Base Rate can continue with base rate system till
repayment of loan (maturity). An option to switch to new MCLR system will also be
provided to the existing borrowers.
Once a borrower of loan opts for MCLR, switching back to base rate system is not
allowed.
Loans covered by government schemes, where banks have to charge interest rates as per
the scheme are exempted from being linked to MCLR.
Like base rate, banks are not allowed to lend below MCLR, except for few categories like
loans against deposits, loans to banks own employees.
Fixed Rate home loans, personal loans, auto loans etc., will not be linked to MCLR.

How MCLR Works? (Example)


For instance, for salaried individuals, XYZ Bank has set a floating rate home loan at one-year
MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the interest rate will
be 9.45% (9.20% +0.25%). This interest rate is valid till 30th April, 2016 (as given in the banks
website). XYZ Bank has decided to set one-year MCLR as the benchmark rate for their home
loans.
Though the MCLR is reviewed monthly, your home loan will be reset every year automatically,
depending on the agreement with the bank.
So, for an Rs.50-lakh home loan on 10th April, 2016, the home loan interest rate would be
9.45%. EMI installments at this rate of interest are to be paid for the next 12 months
Lets say one-year MCLR gets revised to 9. % in April, 2017 and the spread remains the same
then the home loan interest rate will be reset at 9.25% (MCLR of 9% plus spread of 25 bps).

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Open Market Operations (OMO)


OMOs are the market operations conducted by the Reserve Bank of India by way of sale/
purchase of Government securities to/ from the market with an objective to adjust the rupee
liquidity conditions in the market on a durable basis. When the RBI feels there is excess liquidity
in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly,
when the liquidity conditions are tight, the RBI will buy securities from the market, thereby
releasing liquidity into the market.

BASEL
Basel Committee on Banking Supervision, committee of the Bank for International Settlements,
an institution that promotes financial and monetary cooperation among the worlds central banks.
The Basel Committee on Banking Supervision was created in 1974 as an ongoing forum to
discuss banking supervisory matters.
The Basel Committee is guided by two overarching principles: no banking system should operate
unsupervised, and supervision of banks must be adequate. The work of the Basel Committee is
executed primarily through four subcommittees: the Accord Implementation Group, the Policy
Development Group, the Accounting Task Force, and the International Liaison Group. The
committee is best known for developing guidelines and standards in the areas of capital
adequacy, for overseeing cross-border banking activities, and for developing the core principles
of effective banking supervision.

Currently there are 27 member nations in the committee which also includes India. Basel
guidelines refer to broad supervisory standards formulated by this group of central banks - called
the Basel Committee on Banking Supervision (BCBS). The set of agreements by the BCBS,
which mainly focuses on risks to banks and the financial system, is called the Basel accord. The
purpose of the accord is to ensure that financial institutions have enough capital to meet
obligations and absorb unexpected losses. India has accepted Basel accords for the banking
system.
Basel I Norms
In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as
Basel I. It focused almost entirely on credit risk. It defined capital and structure of risk weights
for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
Basel II Norms
In June 2004, Basel II guidelines were published by BCBS, which were considered to be the
refined and reformed versions of Basel I accord. The guidelines were based on three parameters,
which the committee calls as pillars:
1. Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy
requirement of 8% of risk assets.

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2. Supervisory Review: According to this, banks were needed to develop and use better risk
management techniques in monitoring and managing all the three types of risk that a bank faces,
viz. credit, market and operational risk.
3. Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily
disclose their CAR, risk exposure, etc. to the central bank.
III Norms
In 2010, Basel III guidelines were released. These guidelines were introduced in response to the
financial crisis of 2008. A need was felt to further strengthen the system as banks in the
developed economies were under-capitalized, over-leveraged and had a greater reliance on shortterm funding. Also the quantity and quality of capital under Basel II were deemed insufficient to
contain any further risk. Basel III norms aim at making most banking activities such as their
trading book activities more capital-intensive. The guidelines aim to promote a more resilient
banking system by focusing on four vital banking parameters viz. capital, leverage, funding and
liquidity.
Note that Capital Adequacy Ratio is also known as Capital to Risk (Weighted) Assets Ratio
(CRAR).

Changes proposed in BASEL III over BASEL II norms:


a) Better Capital Quality: One of the key elements of Basel III is the introduction of much
stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This
in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.
b) Capital Conservation Buffer: Another key feature of Basel III is that now banks will be
required to hold a capital conservation buffer. The buffer will be an additional 2.5% of Common
Equity Tier 1 capital requirement. The aim of asking to build conservation buffer is to ensure
that banks maintain a cushion of capital that can be used to absorb losses during periods of
financial and economic stress.
c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical
buffer has been introduced with the objective to increase capital requirements in good times and
decrease the same in bad times. The buffer will slow banking activity when it overheats and will
encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%
and will extend the capital conservation buffer previously described.
d) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement
for common equity, the highest form of loss-absorbing capital, is 5.5% of total risk-weighted
assets. The overall Tier 1 capital requirement, consisting of not only common equity but also
other qualifying financial instruments, is 7%. Although the minimum total capital requirement is
9% level, yet the required total capital will increase to 11.5% when combined with the capital
conservation buffer.
e) Leverage Ratio: A review of the financial crisis of 2008 has indicated that the value of many
assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a
leverage ratio to serve as a safety net. A leverage ratio is the relative amount of Tier 1 capital to
total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking
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sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage
ratio is introduced in March 2019.
f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created.
A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be
introduced in a phased manner ending 2018.

The goal of the liquidity coverage ratio (LCR) is to ensure that banks have adequate, high quality
liquid assets to survive a short-term stress scenario. The definition of the standard is as follows:

The goal of the net stable funding ratio (NSFR) is to protect banks over a longer time horizon.
The net stable funding ratio promotes a sustainable maturity structure for assets and liabilities by
creating incentives for banks to use more stable funding sources.

Available stable funding sources (ASF) include Capital, preferred stock with a maturity of more
than one year, liabilities with an effective maturity of more than one year, non-maturity deposits
and time deposits that would be expected to stay at the bank in periods of extended stress, the
proportion of wholesale funds that would be expected to stay at the bank in periods of extended
stress.
The building blocks of Basel III are by and large higher and better quality capital, an
internationally harmonized leverage ratio to constrain excessive risk taking, capital buffers which
would be built up in good times so that they can be drawn down in times of stress, minimum
global liquidity standards, and stronger standards for supervision, public disclosure and risk
management.

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Implementation of BASEL III in India
RBI has mandated implementation of BASEL III norms in India by March 2019 in a phased
manner. The table below shows the implementation of these norms:-

The LCR started on March 1, 2015 and reaching minimum 100% on March 1, 2019, while the
NSRF will be introduced by the January 1, 2018.

Impact of BASEL III on Indian Banks


Higher Capital Requirement: Due to introduction of capital conversation buffer from 2015,
banks would require capital infusion. According to an estimate, for public banks (i.e. SBI & its
associates and nationalized banks) this capital infusion would be of the order of INR 2.4 trillion.
It can be brought in by two methods
a) Divestment of promoters equity (Governments stake)
b) Capital infusion by the government budgetary allocation. Since divestment of such a large
portion of equity would be impractical, the most probable choice of capital accumulation for
these banks would be through budgetary allocation, which could impact government efforts to
improve its fiscal deficit situation. In the latest budget government has allocated around INR
25000 crore for the process of capital infusion. This stress of fiscal deficit could in a way impact
economic growth, inflation and thereby bank profitability.
Return on Equity (ROE): Apart from capital infusion by the government, these banks will have
to raise capital from the market, pushing up the interest rates and subsequently cost of capital,
which would put pressure on ROE of the banks, thereby forcing them to increase their lending
rates to recover their losses.
Yield on Assets: On account of higher deployment of funds in liquid assets that give
comparatively lower returns, banks' yield on assets, and thereby their profit margins, may be
under pressure.
As part of its goal towards achieving BASEL implementation banks would look forward for the
following course of action:

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Change in Business Mix: Banks would look forward to accumulate assets which have lesser
risk weight. As a result of this assets such as retail loans might be given priority over corporate
loans. Within corporate loans as well, banks would look to shift towards shorter term loans
which will have lesser risk weight associated to them.
Low Cost Funding: Implementation of BASEL III norms would be easier if banks have a stable
low cost deposit base. More banks would look forward to increase their CASA ratio which will
ensure lowest cost funds available to them.

Managing financial Risks for Banks-Asset Liability Management


The income of banks comes mostly from the spreads maintained between total interest income
and total interest expense. The higher the spread the more will be the NIM. There exists a direct
correlation between risks and return. As a result, greater spreads only imply enhanced risk
exposure. But since any business is conducted with the objective of making profits and achieving
higher profitability is the target of a firm, it is the management of the risk that holds key to
success and not risk elimination.
There are three different but related ways of managing financial risks.

The first is to purchase insurance. But this is viable only for certain type of risks such as
credit risks, which arise if the party to a contract defaults.

The second approach refers to asset liability management (ALM). This involves careful
balancing of assets and liabilities. It is an exercise towards minimizing exposure to risks
by holding the appropriate combination of assets and liabilities so as to meet earnings
target of the firm.

The third option, which can be used either in isolation or in conjunction with the first two
options, is hedging. It is to an extent similar to ALM. But while ALM involves onbalance sheet positions, hedging involves off-balance sheet positions. Products used for
hedging include futures, options, forwards and swaps.

It is ALM, which requires the most attention for managing the financial performance of banks.
Asset-liability management can be performed on a per-liability basis by matching a specific asset
to support each liability. Alternatively, it can be performed across the balance sheet. With this
approach, the net exposure of the banks liabilities is determined, and a portfolio of assets is
maintained, which hedges those exposures.
Asset-liability analysis is a flexible methodology that allows the bank to test interrelationships
between a wide variety of risk factors including market risks, liquidity risks, actuarial risks,
management decisions, uncertain product cycles, etc. However, it has the shortcoming of being
highly subjective. It is up to the bank to decide what mix would be suitable to it in a given
scenario. Therefore, successful implementation of the risk management process in banks would
require strong commitment on the part of the senior management to integrate basic operations
and strategic decision making with risk management.
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The scope of ALM function can be described as follows:

Liquidity risk management.


Management of market risks.
Trading risk management.
Funding and capital planning
Profit planning and growth projection.

ALM process will involve the following steps:

Reviewing the interest rate structure and comparing the same to the pricing of both assets
and liabilities. This would help in highlighting the impending risk and the need for
managing the same.

Examining loan and investment portfolio in the light of forex and liquidity risk. Due
consideration should be given to the affect of these risks on the value and cost of
liabilities.

Determining the probability of credit risk that may originate due to interest rate
fluctuations or otherwise, and assess the quality of assets.

Reviewing the actual performance against the projections made. Analyzing the reasons
for any affect on the spreads.

Other Financial risks associated with Banks


As financial intermediaries, banks assume two primary types of risk as they manage the flow of
money through their business. Interest rate risk is the management of the spread between interest
paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower
will default on a loan or lease, causing the bank to lose any potential interest earned as well as
the principal that was loaned to the borrower. As investors, these are the primary elements that
need to be understood when analyzing a bank's financial statement.
Interest Rate Risk
The primary business of a bank is managing the spread between deposits (liabilities, loans and
assets). Basically, when the interest that a bank earns from loans is greater than the interest it
must pay on deposits, it generates a positive interest spread or net interest income. The size of
this spread is a major determinant of the profit generated by a bank. This interest rate risk is
primarily determined by the shape of the yield curve.
As a result, net interest income will vary, due to differences in the timing of accrual changes and
changing rate and yield curve relationships. Changes in the general level of market interest rates
also may cause changes in the volume and mix of a bank's balance sheet products. For example,
when economic activity continues to expand while interest rates are rising, commercial
loan demand may increase while residential mortgage loan growth and prepayments slow.
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Banks, in the normal course of business, assume financial risk by making loans at interest rates
that differ from rates paid on deposits. Deposits often have shorter maturities than loans and
adjust to current market rates faster than loans. The result is a balance sheet mismatch between
assets (loans) and liabilities (deposits). An upward sloping yield curve is favorable to a bank as
the bulk of its deposits are short term and their loans are longer term. This mismatch of
maturities generates the net interest revenue banks enjoy. When the yield curve flattens, this
mismatch causes net interest revenue to diminish
One way banks try to overcome the impact of the flattening of the yield curve is to increase the
fees they charge for services. As these fees become a larger portion of the bank's income, it
becomes less dependent on net interest income to drive earnings.
Changes in the general level of interest rates may affect the volume of certain types of banking
activities that generate fee-related income. For example, the volume of residential mortgage
loan originations typically declines as interest rates rise, resulting in lower originating fees. In
contrast, mortgage-servicing pools often face slower prepayments when rates are rising, since
borrowers are less likely to refinance. As a result, fee income and associated economic
value arising from mortgage servicing-related businesses may increase or remain stable in
periods of moderately rising interest rates.
When analyzing a bank, you should also consider how interest rate risk might act jointly with
other risks facing the bank. For example, in a rising rate environment, loan customers may not be
able to meet interest payments because of the increase in the size of the payment or a reduction
in earnings. The result will be a higher level of problem loans. An increase in interest rates
exposes a bank with a significant concentration in adjustable rate loans to credit risk. For a bank
that is predominately funded with short-term liabilities, a rise in rates may decrease net interest
income at the same time that credit quality problems are on the rise.
Credit Risk
Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail in
meeting its obligations in accordance with agreed terms. When this happens, the bank will
experience a loss of some or all of the credit it provided to its customer. To absorb these losses,
banks maintain a provision for loan and lease losses.
In essence, this provision can be viewed as a pool of capital specifically set aside to absorb
estimated loan losses. This allowance should be maintained at a level that is adequate to absorb
the estimated amount of probable losses in the institution's loan portfolio.
Actual losses are written off from the balance sheet account for loan and lease losses.
Arriving at the provision for loan losses involves a high degree of judgment, representing
management's best evaluation of the appropriate loss to reserve. Because it is a management
judgment, the provision for loan losses can be used to manage a bank's earnings.
An investor should be concerned that this bank is not reserving sufficient capital to cover its
future loan and lease losses.
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A careful review of a bank's financial statements can highlight the key factors that should be
considered before making a trading or investing decision. Investors need to have a good
understanding of the business cycle and the yield curve - both have a major impact on the
economic performance of banks. Interest rate risk and credit risk are the primary factors to
consider as a bank's financial performance follows the yield curve.

Money Markets
A money market is a market for borrowing and lending of short-term funds. It deals in funds and
financial instruments having a maturity period of one day to one year. It is a mechanism through
which short-term funds are loaned or borrowed and through which a large part of financial
transactions of a particular country or of the world are cleared. Money market securities consist
of negotiable certificates of deposit (CDs), bankers acceptances, Treasury bills, commercial
paper, municipal notes, federal funds and repurchase agreements (repos).

Money Markets in India


In order to enhance the transmission of monetary policy, RBI has consistently encouraged
development of money market. The Indian money market consists of highly liquid short term
instruments which are explained below:Treasury Bills
This market deals in Treasury Bills of short term duration issued by RBI on behalf of
Government of India. At present three types of treasury bills are issued through auctions, namely
91 day, 182 day and 364 day treasury bills. Interest is determined by market forces. Treasury
bills are available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Periodic
auctions are held for their issue. T-bills are a highly liquid, readily available and risk free
instrument.

Call Money and Notice Market


Call money market is the market for extremely short-period borrowings. Under call money
market, funds are transacted on overnight basis. Mostly the participants are banks. Therefore it is
also called Inter-Bank Money Market. In this market the rate at which funds are borrowed and
lent is called the call money rate. The call money rate is determined by demand and supply of
short term funds. Under notice money market funds are transacted for 2 days and 14 days period.
The lender issues a notice to the borrower 2 to 3 days before the funds are to be paid. On receipt
of notice, borrower has to repay the funds.
The call money market rate generally hovers between the repo and the reverse repo rate as any
rate offered above the repo rate or below the reverse repo rate creates an opportunity for
arbitrage. However if still it is consistently above the repo rate then it signifies that banks have
borrowed their limit from the LAF facility. Such a situation shows that there is huge pressure on
liquidity and RBI then takes steps to ensure that there is sufficient liquidity available in the
system.

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Under notice money market funds are transacted for 2 days and 14 days period. The lender issues
a notice to the borrower 2 to 3 days before the funds are to be paid. On receipt of notice,
borrower has to repay the funds.
Term money refers to borrowing/lending of funds for a period exceeding 14 days and generally
has maturity up to 1 year. The interest rates on such funds depend on the surplus funds available
with lenders and the demand for the same.
Commercial Papers (CP)
The Commercial Papers can be issued by listed companies which have working capital of not
less than INR 5 crores. CPs could be issued in multiple of INR 25 lakhs with the minimum size
of issue being INR 1 crore. At present the maturity period of CPs ranges between 7 days to 1
year. CPs are issued at a discount to the face value and redeemed at face value.
Certificate of Deposits (CDs)
CDs are issued by Commercial banks and development financial institutions. They are
unsecured, negotiable promissory notes issued at a discount to the face value. The scheme of
CDs was introduced in 1989 by RBI. The main purpose was to enable the commercial banks to
raise funds from market. The maturity period of CDs ranges from 3 months to 1 year. They are
issued in multiples of INR 25 lakh, subject to a minimum size of INR 1 crore. CDs can be issued
at discount to face value. They are freely transferable but only after the lock-in-period of 45 days
after the date of issue. However the size of CDs in India is relatively very small.
Collateralized Borrowing and Lending Obligation (CBLO)
In a similar manner like Repo, an organization with surplus funds can lend out its money in the
market to other organizations in need of funds with collateral in place. While call money market
caters to the need of banks and primary dealers, CBLO generally lends out to mutual funds,
insurance & financial companies etc. in addition to primary dealers and banks. The only
difference is that CBLO involves collateral. Interested parties are required to open Constituent
Subsidiary General Ledger (CSGL) Account with Clearing Corporation of India Limited (CCIL)
for depositing securities as collateral.
Mumbai Inter-Bank Offered Rate (MIBOR)
MIBOR can be defined as the interest rate at which banks can borrow funds, in marketable size,
from other banks in the Indian interbank market. The association of bond dealers, local currency
traders and bankers formed a new firm to fix the Mumbai Inter-Bank Offer Rate (MIBOR), in
line with a Reserve Bank of India (RBI) panel recommendation which seeks to avoid a Libor
(London Interbank Offer Rate) like fiasco in India. The Fixed Income Money Market and
Derivatives Association of India (FIMMDA), the Foreign Exchange Dealers Association of
India (FEDAI) and the Indian Banks Association have together formed a new firm named the
Board of Financial Benchmarks India Pvt. Ltd (FBIL), which will henceforth administer the
MIBOR. MIBOR is currently used for a majority of deals struck for interest rate swaps, forward
rate agreements, floating rate debentures and term deposits.
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Currently the application of MIBOR is meager when compared with the London Interbank Offer
Rate (LIBOR). However RBI has restructured the LAF such that the term repo window is getting
shaped (as only 0.25% of NDTL being allowed to be borrowed through overnight repo and
remaining 0.75% of NDTL through term repos). This would lead to the existence and relevance
of the term curve. If the term curve comes in the market, then MIBOR will have a larger role.
Over a period of time, inter-bank term money quotes will be based on the term curve. At that
time, MIBOR may also be used for pricing of money market instruments. LIBOR is a global
benchmark for interest rates. It is used as the base for deciding interest rates on loans, savings
and mortgages. It is also used as a base rate for many financial products, such as futures, options
and swaps.

Role of Money Markets in Monetary Policy Transmission


The money market forms the first and foremost link in the transmission of monetary policy
impulses to the real economy. Policy interventions by the central bank along with its market
operations influence the decisions of households and firms through the monetary policy
transmission mechanism. The key to this mechanism is the total claim of the economy on the
central bank, commonly known as the monetary base or high-powered money in the economy.
The central banks power to conduct monetary policy stems from its role as a monopolist, as the
sole supplier of bank reserves, in the market for bank reserves. Following are the instruments
used by it for the same.

Open Market Operations


When RBI buys (sells) securities, it credits (debits) the reserve account of the seller (buyer)
bank. This increases (decreases) the total volume of reserves that the banking system collectively
holds. Expansion (contraction) of the total volume of reserves in this way leads to banks to
exchange reserves for other remunerative assets. Since reserves earn low interest banks typically
would exchange them for some interest bearing asset such as Treasury Bills or other short-term
debt instruments. If the banking system has excess (inadequate) reserves, banks would seek to
buy (sell) such instruments. If there is a general increase (decrease) in demand for these
securities, it would result in increase (decline) in security prices and decline (increase) in interest
rates.
Cash Reserve Requirement
Lowering (increasing) the cash reserve requirement, and, therefore, reducing (increasing) the
demand for cash has roughly the same impact as an expansionary (contractionary) open market
operation, which increases (decreases) the supply of reserves creating downward (upward)
pressure on interest rates.
Repo Rate
The rate at which the RBI lends money to commercial banks is called repo rate, also known as
the policy rate, which usually acts as the ceiling on call rates in the short-term market. Similarly,
central bank absorbs liquidity at a rate which acts as the floor for short-term market interest rates
by borrowing reserves from banks in exchange for assets, also known as reverse repo. The repo
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rate acts as a ceiling because injecting liquidity at the ceiling rate would ensure that banks do not
have access to these funds for arbitrage opportunities whereby they borrow from the central bank
and deploy these funds in the market to earn higher interest rates. Similarly, liquidity absorption
by the RBI has to be at the floor rate since deployment of funds with the central bank is free of
credit and other risks. Typically, the objective of the central bank is to modulate liquidity
conditions by pegging short-term interest rate.

Government Finances
Every year, the Government puts out a plan for its income and expenditure for the coming year.
This is known as the annual Union Budget. A budget is said to have a fiscal deficit when the
Government's expenditure exceeds its income. When faced with deficits governments have one
of the two options:
To raise money through taxes in order to bridge the deficit
To borrow more money in order to meet its spending requirements
Fiscal deficit
The size of fiscal deficit has substantial effect on the economy of India. While small amounts of
fiscal deficits generally have a positive effect on the economy, large amounts are detrimental for
the health of the economy. In case of high fiscal deficit, governments generally borrow more
money thereby leading to a shortage of funds for the industry and a rise in interest rates. This
hurts industrial growth in the country. Governments can also resort to printing money to pay off
their debts and this could also increase inflation.
Governments fiscal deficit for FY 16 stood at 3.92% of GDP which was better compared to
4.1% of FY 15. The budgeted estimate of fiscal deficit for FY 17 is around 3.5% of GDP.
Current Account Deficit
Current account deficit occurs when a country's total imports of goods, services and transfers are
greater than the country's total export of goods, services and transfers. This situation makes a
country a net debtor to the rest of the world. In order to tackle with this situation the central bank
issues promissory note. This in turn tightens the money supply and increases the cost of supply
of funds for the banks.
Current account deficit narrowed sharply to USD 0.3 billion, or 0.1 per cent of GDP, in the
fourth quarter of 2015-16 from USD 7.1 billion, or 1.3 per cent, in third quarter, on account of
lower trade gap. The overall Current account deficit for 2015-16 shrank to 1.1% as compared to
1.3% in 2014-15. During the fiscal, there was decline in net invisible receipts, reflecting
moderation in both net services earnings and private transfer receipts.Net FDI inflows during the
last fiscal stood at USD 36 billion, up sharply by 15.3 per cent over the level in 201415.Portfolio investment, however, recorded a net outflow of USD 4.5 billion during the fiscal as
against a net inflow of USD 40.9 billion in 2014-15.
In 2015-16, there was an accretion of USD 17.9 billion to foreign exchange reserves (on BoP
basis) as compared with USD 61.4 billion in 2014-15
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Major Banking Sector Reforms since 1991


The economic reforms initiated in 1991 also embraced the banking system. Following are the
major reforms aimed at improving efficiency, productivity and profitability of banks:

New banks licensed in private sector to inject competition in the system - 10 in 1993 and 2
more in 2003. Two commercial banks licenses for Bandhan and IDFC Ltd. were issued in
2014. Licenses for payment banks have been issued in 2015. Licenses for small banks are
expected within a few weeks.
Aggregate foreign investment (FDI, FII and NRI) up to 74% allowed in private sector banks
Listing of PSBs on stock exchanges and allowing them to access capital markets for
augmenting their equity, subject to maintaining Government shareholding at a minimum of
51%. Private shareholders represented on the Board of PSBs Progressive reduction in statutory
pre-emption (SLR and CRR) to improve the resource base of banks so as to expand credit available to
private sector. SLR currently at 22% (38.5% in 1991) and CRR at 4% (15% in 1991)
Adoption of international best practices in banking regulation. Introduction of prudential norms on
capital adequacy, IRAC (income recognition, asset classification, provisioning), exposure norms etc.

Phased liberalization of branch licensing. Banks can now open branches in Tier 2 to Tier 6
centres without prior approval from the Reserve Bank
Deregulation of a complex structure of deposit and lending interest rates to strengthen
competitive impulses, improve allocative efficiency and strengthen the transmission of
monetary policy
Base rate (floor rate for lending) introduced (July 2010). Prescription of an interest rate floor
on savings deposit rate withdrawn (October 2011)
Functional autonomy to PSBs
Use of information technology to improve the efficiency and productivity, enhance the
payment and settlement systems and deepen financial inclusion
Improvements in the risk management culture of banks
Introduction of Indradhanush to improve functioning of Public Sector Banks
The minimum daily maintenance of CRR reduced from 95 per cent of the requirement to 90
per cent effective April 16, 2016.
The policy rate corridor was narrowed from +/-100 bps to +/- 50 bps by reducing the MSF
rate by 75 bps to 7.0 per cent and increasing the reverse repo rate by 25 bps to 6.0 per cent
for finer alignment of the weighted average call rate (WACR) with the policy repo rate

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Recent Developments
The Insolvency and Bankruptcy code, 2016
The Insolvency and Bankruptcy Code, 2015 was introduced by the Minister of Finance, Mr.
Arun Jaitley, in Lok Sabha on December 21, 2015, and subsequently referred to a Joint
Committee of Parliament. The Committee submitted its recommendations and a modified Code
based on its suggestions on April 28, 2016. This modified Code was passed by Lok Sabha on
May 5, 2016. The Code creates a framework for resolving insolvency in India. Insolvency is a
situation where an individual or a company is unable to repay their outstanding debt. The
bankruptcy code has provisions to address cross-border insolvency through bilateral agreements
with other countries. It also proposes shorter, aggressive time frames for every step in the
insolvency processright from filing a bankruptcy application to the time available for filing
claims and appeals in the debt recovery tribunals, National Company Law Tribunals and courts.
The Code will apply to companies, partnerships, limited liability partnerships, individuals and
any other body specified by the central government.

Insolvency Resolution Process: The Code specifies similar insolvency resolution processes for
companies and individuals, which will have to be completed within 180 days. This limit may be
extended to 270 days in certain circumstances. The resolution process will involve negotiations
between the debtor and creditors to draft a resolution plan. The process will end under two
circumstances, (i) when the creditors decide to evolve a resolution plan or sell the assets of the
debtor, or (ii) the 180-day time period for negotiations has come to an end. In case a plan cannot
be negotiated upon during the time limit, the assets of the debtor will be sold to repay his
outstanding dues. The proceeds from the sale of assets will be distributed based on an order of
priority.
India Post Payments Bank Incorporated
The India Post Payments Bank Limited has received the Certificate of Incorporation from the
Registrar of Companies, Ministry of Corporate Affairs yesterday under the Companies Act 2013.
This would be the first PSU under the Department of Posts. This has happened in the wake of
Prime Minister Shri Narendra Modis Independence Day address, raising the expectations of the
people from the soon to be set up India Post Payments Bank. With this move the Department of
Posts has cleared an important milestone on this journey.
With the incorporation, the Board of the India Post Payments Bank Limited is likely to be
constituted soon. The incorporation of the IPPB Ltd is a significant step forward as this also
paves the way for the bank to begin hiring of banking professionals to set up the bank and begin
its operations in 2017. The Department of Posts is expected to complete the roll out of its
branches all over the country by September 2017. This could be the fastest roll out for a bank
anywhere in the world.
The aspiration for the India Post Payments Bank is to become the most accessible bank in the
world riding on state of the art banking and payments technology. Coupled with the physical
presence across 1.55 lakh post offices and the reach of The Dakiya, the India Post Payments
Bank aims to become a powerful and effective vehicle of real financial inclusion in the country.
It is poised to create a national payments architecture riding on a modern payments platform and

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ubiquitous information and communication technologies that can be accessed by all users and
service providers like never before. The stakeholders of the India Post Payments Bank within the
Government and outside are looking at this new entity as a catalyst to social and financial
inclusion.

Unified Payments Interface:


National Payments Corporation of India (NPCI), the umbrella organisation for all retail
payments system in India on Thursday said that the Unified Payments Interface (UPI) was live
for customers of 21 banks.
UPI is a payments solution that empowers a recipient to initiate the payment request from a
Smartphone. It facilitates virtual payment address as a payment identifier for sending and
collecting money and works on single-click two-factor authentication. It also provides an option
for scheduling push and pulls transactions for various purposes such as sharing bills among
peers.
Built on top of the IMPS (Immediate Payment Service platform), UPI needs to have the
beneficiarys UPI ID - a virtual identity like an email address. This could be your name, or your
phone number, so for example, if your phone number is 1234567890, then your virtual address
could be 1234567890@sbi (if your bank is SBI) or 1234567890@icici (if youre an ICICI bank
customer), and so on.
One can use the UPI app instead of paying cash on delivery on receipt of product from online
shopping websites and can pay for miscellaneous expenses like paying utility bills, over-the counter payments, barcode (scan and pay) based payments, donations, school fees and other such
unique and innovative use cases Some of the banks that are going live with UPI are - Andhra
Bank, Axis Bank, Bank of Maharashtra, Bhartiya Mahila Bank, Canara Bank, Oriental Bank of
Commerce, Union Bank of India and Vijaya Bank, Karnataka Bank, UCO Bank, Union Bank of
India, United Bank of India, Punjab National Bank, South Indian Bank, Vijaya Bank and YES
Bank among others.

Scheme for Sustainable Structuring of Stressed Assets


The Reserve Bank of India (RBI) has allowed banks to conduct deep restructuring of large
accounts to revive projects that can be saved, effectively throwing a lifeline to promoters who
risked losing their companies. Banks are anyway struggling to dispose of many stressed assets
they have already acquired and have no clue what to do next. Accounts that are worth Rs 500
crore or more and have already started commercial operations will be eligible for the new recast
scheme, titled 'Scheme for Sustainable Structuring of Stressed Assets. Only those promoters who
have shown no malfeasance in their actions while running the show can ask for the permission to
continue with the management, even if they get reduced to minority shareholders in the process.
The two sectors which would benefit are steel and power.
Some of the completed projects in these sectors were hit by external factors. Deep restructuring
is done to ensure long-term sustenance. The strategic debt restructuring (SDR) scheme was of
limited use in such cases. Under it, banks could convert debt into equity and take control of a

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company and sell off the assets. However, if they were not able to dispose of the assets within 18
months, the lenders had to incur heavy provisions.
In about a dozen companies where banks invoked SDR, they have not found a single buyer,
defeating the entire purpose of loan recovery and at the cost of running down the company,
which often times could be just victims of economic downturn. Stating the 18-month timeframe
of SDR was not enough for making full provisions on large loans, banks had asked for more
time, necessitating the new scheme
Peer to Peer lending:
The Reserve Bank of India has came up with a discussion paper on peer-to-peer lending (P2P),
seeking to regulate the fast emerging crowd funding platforms as the new financing model has
assumed importance too significant to be ignored.
Interestingly, the platform owners and investors welcomed the development as regulation gives
RBIs stamp of approval to a business that is completely banned in countries like Japan and
Israel.
In fact, RBI itself is aware of this and sounded a little hesitant in giving this recognition to the
business model. But the central bank officials, including Governor Raghuram Rajan, have said
the RBI cannot remain indifferent to new innovation in financing activities and growth in P2P
sector. To allow regulation, RBIs discussion paper said the platforms should adopt a company
structure that can then be regulated by the central bank. Currently, the P2P platforms are run by
individuals, proprietorship, partnership or limited liability partnerships areas outside RBIs
jurisdiction. The P2P platforms are largely technology companies registered under the
Companies Act and acting as an aggregator for lenders and borrowers thereby, helping create a
match between them.
Presently, there are around 30 start-up P2P lending companies in India. The main features of the
paper are:

RBI plans to treat it as intermediary NBFC


Minimum capital requirement is Rs 2 crore
Should not take deposits
Cannot show lending and borrowing funds in its balance sheet
Money should go directly from lender to borrower
Can only take fees, provide creditworthiness info
Should not provide cross-border transactions
Management should be stationed in India

Asset Quality Review


Reserve Bank of India inspectors check bank books every year as part of its annual financial
inspection (AFI) process. However, a special inspection was conducted in 2015-16 in the
August-November period. This was named as Asset Quality Review (AQR). In a routine AFI, a
small sample of loans is inspected to check if asset classification was in line with the loan
repayment and if banks have made provisions adequately.

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However, in the AQR, the sample size was much bigger and in fact, most of the large borrower
accounts were inspected to check if classification was in line with prudential norms. Some
reports suggest that a list of close to 200 accounts was identified, which the banks were asked to
treat as non-performing. Banks were given two quarters, October-December and January-March
of 2016 to complete the asset classification.
Impact on Profitability
The AQR created havoc on banks profit & loss accounts as many large lenders slipped into
losses in both the said quarters, which resulted in some of them reporting losses for the full
financial year. Record losses were posted in Q4 of FY16 by many large lenders like Bank of
Baroda (Rs.3,230 crore), Punjab National Bank (Rs.5,367 crore), IDBI Bank (Rs.1,376 crore)
to name a few.

Almost all public sector banks were impacted, while the impact in the private sector was limited
to biggies such as ICICI Bank and Axis Bank. HDFC Bank the second-largest private sector
lender emerged unscathed from the crisis as its exposure to big-ticket infrastructure projects
was relatively small.
Bad loans in the Indian banking system jumped 80 per cent in FY16, according to RBI data,
mainly on account of the AQR.
Masala Bonds
Masala bond is a term used to refer to a financial instrument through which Indian entities can
raise money from overseas markets in the rupee, not foreign currency. These are Indian rupee
denominated bonds issued in offshore capital markets. The rupee denominated bond is an
attempt to shield issuers from currency risk and instead transfer the risk to investors buying these
bonds. Interestingly currency risk is borne by the investor and hence, during repayment of bond
coupon and maturity amount, if rupee depreciates, RBI will realize marginal saving. Experts
believe that Indian currency is still a bit overvalued. In a way masala bond is a step to help
internationalize the Indian rupee. Investors in these bonds will have a clear understanding and
view on the Indian rupee risks. Therefore, a stable Indian currency would be key to the success
of these bonds. It is believed that as the investors in a masala bond will bear the currency risk,
they would demand a currency risk premium on the coupon and hence borrowing cost for Indian
corporates through this route would be slightly higher. It may still be cheaper if one considers the
currency risk. Though raised in Indian currency, these bonds will be considered as part of foreign
borrowing by Indian corporate and hence would have to follow the RBI norms in this regard.
Under the automatic route, companies can raise as much as $750 million per annum through
Masala bonds.

Guidelines:
The broad contours of the framework are as follows:
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Eligible borrowers: Any corporate or body corporate as well as Real Estate Investment Trusts
(REITs) and Infrastructure Investment Trusts (InvITs).
Recognized investors: Any investor from a Financial Action Task Force (FATF) compliant
jurisdiction.
Maturity: Minimum maturity period of 5 years.
All-in-cost: All in cost should be commensurate with prevailing market conditions.
Amount: As per extant ECB policy.
End-uses: No end-use restrictions except for a negative list.

RBI prescribes norms for enhancing credit to large borrowers


In order to mitigate the risk of high exposure of banking system to any single borrower, Reserve
Bank today came out with prudential norms on enhancing credit supply to large borrowers
through market mechanism. As per the norms, which will come into affect from April 1, 2017,
incremental exposure of banking system to a specified borrower beyond normally permitted
lending limit (NPLL) will be deemed to carry higher risk which will be recognised by way of
additional provisioning and higher risk weights. Additional provisions of 3 percentage points
over and above the applicable provision on the incremental exposure of the banking system in
excess of NPLL, which shall be distributed in proportion to each bank's funded exposure to the
specified borrower
Specified borrower' means a borrower with an aggregate of the fund-based credit limits (ASCL)
of more than Rs 25,000 crore at any time during 2017-18, Rs 15,000 crore at any time during
2018-19 and Rs 10,000 crore at any time from April 1, 2019, onwards.
Earlier, the RBI had come out with a discussion paper proposing a framework for addressing the
concentration risk of the banking system arising from its exposures towards a single counter
party. Also, an additional risk of 75 percentage points over and above the applicable risk weight
for the exposure to the specified borrower has been provided in the norms.

Loan to women SHGs at 7%


The Reserve Bank today asked banks to provide loans to women self-help groups (SHGs) at 7
per cent per annum, as per the government's revised guidelines for 2016-17.
All women SHGs will be eligible for interest subvention on credit up to Rs 3 lakh at 7 per cent
per annum (under Deendayal Antyodaya Yojana-National Rural Livelihoods Mission). SHGs
availing capital subsidy under SGSY in their existing credit outstanding will not be eligible for
benefit under this scheme.The banks will lend to all the women SHGs in rural areas at 7 per cent
in 250 districts, it said. All banks will be subvented to the extent of difference between the
weighted average interest charged and 7 per cent, subject to the maximum limit of 5.5 per cent
for 2016-17, it said. This subvention will be available to all the banks on the condition that they
make SHG credit available at 7 per cent annually in the 250 districts

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Bharat Bill Payment System
Bharat Bill Payment System (BBPS) is an integrated bill payment system which will offer
interoperable bill payment service to customers online as well as through a network of agents on
the ground. The system will provide multiple payment modes and instant confirmation of
payment.
Bharat Bill Payment Central Unit (BBPCU) will be a single authorized entity operating the
BBPS. The BBPCU will set necessary operational, technical and business standards for the entire
system and its participants, and also undertake clearing and settlement activities. As indicated in
the circular dated November 28, 2015 National Payment Corporation (NPCI) has been identified
to act as BBPCU. It will be an authorized entity under the Payment and Settlement Systems Act,
2007.

Bharat Bill Payment Operating Units (BBPOUs) will be authorised operational entities,
adhering to the standards set by the BBPCU for facilitating bill payments online as well as
through a network of agents, on the ground
Banks and non-bank entities presently engaged in any of the above bill payment activities falling
under the scope of BBPS and desirous of continuing the activity are mandatorily required to
apply for approval / authorisation to Reserve Bank of India under the Payment and Settlement
Systems (PSS) Act 2007. Paytm, PayU India and Oxigen have got in-principle approvals for
operating as Bharat Bill Payments Operating Unit, as announced by RBI. A total of 80 requests
were received, out of which 62 were from non-banking entities. Till now, it has given approval
to 33 applicants including aggregators like BillDesk and banks including SBI, ICICI, HDFC,
Axis Bank, Kotak and others.This will allow customers to pay all their bills anytime and
anywhere under the Bharat Bill Payment System (BBPS), and the companies which have
received licenses will provide platforms to offer these services.

As proposed, it is a step towards a cashless economy. It is also expected to make transactions


easier, facilitate micro-payments and instantly recognise transactions. Operators can provide bill
payment facilities through any of the channels under them. For banks, this could be ATMs,
branches, online or mobile apps, while non-banks will need to tie up with a bank for accounting
purposes. Non-banks can also appoint agents with outlets such as kirana store which will display
a BBPS logo.
Monetary Policy Committee
The new MPC is to be a six-member panel that is expected to bring value and transparency to
rate-setting decisions. It will feature three members from the RBI the Governor, a Deputy
Governor and another official and three independent members to be selected by the
Government.A search committee will recommend three external members, experts in the field of
economics, banking or finance, for the Government appointees. The MPC will meet four times a
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year to decide on monetary policy by a majority vote. And if theres a tie, the RBI governor gets
the deciding vote.
Until recently, Indias central bank used to take its monetary policy decisions based on the
multiple indicator approach. Its rate decisions were expected to take into account inflation,
growth, employment, banking stability and the need for a stable exchange rate. This is a tall
order. Thus, RBI (with the Governor as the focal point) would be subject to hectic lobbying
ahead of each policy review and trenchant criticism after it. The Government would clamour for
lower rates while consumers bemoaned high inflation. Bank chiefs would want rate cuts, but
pensioners would want high rates. RBI ended up juggling all these objectives and focussing on
different indicators at different points in time.

Indias shift to an MPC, driven by a clear inflation-targeting framework, if it succeeds, may also
ensure that consumers and investors can look forward to lower inflation rates over the long-term.
The public disclosure of MPC deliberations will also tell you why its members batted for higher
or lower rates.
The Union Budget 2016-17

The proposed Rs 250 billion capital supports to public sector banks (PSBs) is inadequate
at a time when PSBs are experiencing significant pressure on profitability, high gross
non-performing assets amid necessity to comply with stringent Basel III capital
requirements.
The code to deal with bankruptcies in banks, insurance companies and financial sector
entities will help in faster resolution. The proposal to strengthen debt recovery tribunals
will be positive for banking system over the long term.
The proposal to consolidate PSBs will improve efficiencies in the system.
No taxes on profits of companies undertaking housing projects with flats up to 30 sq
meters in four metro cities and 60 sq meters in other cities along with additional
housing loan interest deduction of Rs 50,000 per annum for first-time home buyers
securing loans up to Rs 3.5 million and maximum house value of Rs 5 million has been
proposed. The government also increased the period for claiming interest deduction from
date of acquiring or constructing self-occupied houses to five years from three years.
These reforms will provide a boost to the real estate sector, creating credit growth
opportunities for the housing finance industry.
Non-banking financial companies (NBFCs) are eligible for deduction to the extent of 5%
of their income with respect to provision for bad and doubtful debts because of which
NBFCs net margin will improve.
The government has proposed to amend the Securitisation and Reconstruction of
Financial Assets and Enforcement of Security Interest Act, 2002 or SARFAESI Act,
allowing a single foreign entity to own 100 percent stake in an ARC (compared to 49
percent currently). This might not have a significant impact in the near term as it does not
resolve issues such as mismatch in price expectations of banks and ARCs, as well as
higher equity required by ARCs while purchasing assets

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International Updates:
Negative yield and Quantitative easing in Japan
Negative yield refers to a situation where a bond buyer is guaranteed to make a loss if he holds
the bond till maturity. This is possible when the coupon payments are negative or if the market
value of the bond is less than 0.
Quantitative Easing is the process by which central bank infuses money in the economy so as to
boost spending and growth. The central bank buys financial assets, issued by government, so as
to increase the price of the bond, reducing the yield and simultaneously increasing the money
supply.
Japan has been hit by deflation over the last 2 decades, and has been trying to come out of it
since long. The first series of quantitative easing started in 2001 and continued for 5 years and
yet it failed to get Japan out of the persistent deflation. The latest Quantitative easing started in 2
April 2013 where Bank of Japan was to buy 7tn yen worth of government bonds on a monthly
basis.
At the start of this year Bank of Japan went a step ahead introducing a negative interest rate on
deposits, so as to force people to spend more and hence increase inflation in the economy. Japan
has an ageing population where the numbers of deaths are exceeding the number of births. Thus
a negative interest rate will help motivate people to spend rather than save and hence stimulate
growth. However it is a politically unfavourable move in a country where more than 50% of the
investments are made in fixed deposits with banks. So now it is highly unlikely of a further rate
cut by the Bank of Japan.

This within a couple of weeks resulted in Negative yield in the Japan treasury bonds. This
happened as in times of economic turmoil on the global front , Yen being considered a safe
currency, demand for Yen kept going up, thus cancelling the targeted inflation. Bank of Japan
buying a large amount of government bonds increased the demand and hence the price, thus
lowering the yield. Now however there is an acute shortage of government bonds to buy for the
Bank of Japan, with the most recently 30 year Bond not even recording a single trade in a week
in an attempt to hoard bonds by their owners.
US rate hike Just a matter of when
The case for an increase in the federal funds rate has strengthened in recent months, according to
a speech made by Federal Reserve Chair Janet Yellen at the annual Jackson Hole symposium last
Friday. The remainder of Yellens comments was a discussion of longer term policy issues, such
as the design of the future monetary policy framework. In terms of monetary policy in the near
term, the strength of the labour market in recent months and the improved outlook for activity
and inflation appear to have added to the case for a rate hike. The markets had initially
interpreted Yellens comments with a dovish tilt
Because of the vagueness on the potential timing of the rate hike. However, Vice Chairman
Stanley Fischer later fuelled market expectations of a rate hike potentially happening as early as
September this year during a media interview. Fischer had alluded to the very strong hiring
reports in the US in recent months and the better big numbers as factors that could sway the
rate hike decision. Indeed, the probability of a rate hike this year could hinge on the continued
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strength of the labour market and an improved outlook for growth conditions in the US in the
coming months. Despite the more hawkish Fed rhetoric, the market continues to price in an
extremely shallow interest rate path based on previous guidance by the Fed. Indeed, markets
have still not priced in one full rate hike for the next 12 months. On the Federal Reserves longer
term monetary policy framework, Yellen suggested that future Fed officials could enhance the
existing policy toolkit, which includes asset purchases and forward guidance on rates. For
example, future Fed officials might want to consider buying a broader range of assets as part of
quantitative easing programme, even though the central bank was not considering any of these
additional policy tools right now.
Bank of England cuts rate:
The Bank of Englands Monetary Policy Committee (MPC) sets monetary policy to meet the 2%
inflation target, and in a way that helps to sustain growth and employment. At its meeting
ending 3 August 2016, the MPC voted for a package of measures designed to provide additional
support to growth and to achieve a sustainable return of inflation to the target. This package
comprises:

A cut in official interest rates to 0.25%, the first such move since March 2009;
Plans to pump an additional 60bn in electronic cash into the economy to buy government
bonds, extending the existing quantitative easing (QE) programme to 435bn in total;
Another 10bn in electronic cash to buy corporate bonds from firms making a material
contribution to the UK economy;
As much as 100bn of new funding to banks to help them pass on the base rate cut. Under
this new term funding scheme (TFS) the Bank will create new money to provide loans to
banks at interest rates close to the base rate of 0.25%. The scheme will charge a penalty rate
if banks do not lend;
The growth forecast for the UK for next year was slashed by an unprecedented amount.
Growth would come to a near-standstill over coming months and be much weaker in 2017
and 2018 than predicted before the Brexit vote.

Unnati Sector Report 2016-17 |45

Banking , Financial Services and Insurance

Recent mergers and acquisitions of stakes in the Banking


sector:
State Bank of India merger with its associates and Bhartiya Mahila Bank.
In a definitive push for consolidation in the banking sector, the Union Cabinet has approved the
merger of State Bank of India (SBI) with its five associate lenders and Bharatiya Mahila Bank.
While India's largest lender would reap benefits of scale and a larger balance sheet, it will be a
major challenge to integrate staff and rationalise branches. The SBI network expand, its reach
would multiply. The group will get the benefit of efficiencies to be created from rationalisation
of branches, common treasury pooling and proper deployment of a large skilled resource base. A
significant aspect of employee rationalisation will be aligning the pay structures. The associates
have a little over 70,000 employees, or 34 per cent of SBI's employee base. While SBI
employees receive pension, provident fund and gratuity, those at associate banks do not receive
contributory provident fund.

The details of the merger are:


1)This is the first ever large-scale consolidation in the Indian banking industry.
2) The merger will create a banking behemoth with an asset book of Rs 37 lakh crore.
3) SBI will give 28 of its shares for every 10 shares held of State Bank of and Jaipur.
4) It will give 22 of its shares for every 10 shares held of State Bank of Mysore.
5) The lender will give 22 of its own shares for every 10 shares held of State Bank of
Travancore
6) SBI will give 4,42,31,510 shares with face value of Re. 1 for every 100 crore equity shares of
Bhartiya Mahila Bank.
7) The merger will see SBI's ranking app rove in the Bloomberg's largest bank by asset ranking.
It may well break through the 50-mark in the ranking.
8) SBI's asset base will now be five times larger than the second-largest Indian bank, ICICI
Bank.

IDFC Bank buys Tamil Nadu-based Grama Vidiyal Microfinance


Grama Vidiyal has a customer base of 1.2 million customers with an asset base of Rs.1,500
crore, said Rajiv Lall, chief executive officer of IDFC Bank. The bank has received approval
from the Reserve Bank of India (RBI) for the transaction.
IDFC Bank started banking operations on 1 October 2015, converting from an infrastructure
focused lender into a universal bank. IDFC was one of two entities that got a banking license
from the RBI in 2014 along with Bandhan Bank.
As of the March 2016 ended quarter, IDFC Banks advances stood at Rs.45,699 crore as on 31
March, higher than Rs.43,440 crore as on 31 December. About 95% of these loans were from
large firms and the remaining from smaller firms and retail customers. The banks deposit base
as on 31 March stood at Rs.8,219 crore, of which about Rs.200 crore worth of deposits came
from its retail customers.

Unnati Sector Report 2016-17 |46

Banking , Financial Services and Insurance


IDFC Banks acquisition of a microfinance company comes at a time when growth in the sector
has spiked. The loan portfolio of MFIs stood at Rs.53,233 crore as of 31 March 2016, up 84%
from Rs.28,940 crore a year ago, according to data from the Microfinance Institutions Network
(MFIN), a self-regulatory organization for the industry. However, this 84% jump in loans came
against a much more modest 44% increase in the number of clients, suggesting the average loan
per customer is on the rise. The number of branches and employees also grew at a slower pace of
22% and 36% respectively last fiscal
Canada pension fund buys stake in Kotak Mahindra Bank
Japans Sumitomo Mitsui Banking Corp. on Tuesday sold a large part of the Kotak Mahindra
Bank Ltd stake to Canada Pension Plan Investment Board (CPPIB), which manages 268.6 billion
Canadian dollars ($203.09 billion) in pension fund assets As of 31 December 2015, Sumitomo
held a 3.58% stake in the private-sector lender, while CPPIB held about 3.91%, data from stock
exchanges show. Shares were offered to buyers in the price range of Rs.611.34-636.55 apiece,
according to Bloomberg.
Citigroup Inc. is managing the share sale programme. After the transaction, Sumitomos stake in
the bank will fall to around 1.79%.
The Japanese bank had picked up a 4.5% stake in Kotak Mahindra Bank in 2010 through a
preferential allotment forRs.1,366 crore.
Apart from its investment in Kotak Mahindra Bank, CPPIB has invested in infrastructure, real
estate and private equity industries in India.CPPIBs exposure to the Indian infrastructure sector
is through a Rs.2,000 crore investment in L&T Infrastructure Development Projects Ltd (L&T
IDPL), which was announced in December 2014.

Kotak Mahindra Bank buys 19.9 per cent stake in Airtel M Commerce Services
Kotak Mahindra Bank bought 19.90% stake in Airtel M Commerce Services Ltd (AMSL)
for Rs.98.38 crore to set up a payments bank.
AMSL was one of the 11 entities that were given an in-principle approval in August 2015 by
the Reserve Bank of India for a payments bank. Kotak Mahindra Bank had announced in January
2015 its intention to buy a stake in the Bharti groups company.
AMSL was incorporated in April 2010 as a 100% subsidiary of Bharti Airtel Ltd. It is in the
business of providing the service of semi-closed prepaid instrument and offers services under the
Airtel Money brand name.
Total revenue of AMSL in 2014-15 was Rs.121.4 crore, up from Rs.42.6 crore in the previous
financial year, according to Kotak Mahindra Banks filing to the BSE.

Unnati Sector Report 2016-17 |47

Banking , Financial Services and Insurance

Declining Asset Quality of Banks

Source: Crisil Research


The Gross NPAs have increased steeply to 7.6% in 2015-16 and is expected to reach to 8.5% in
2016-17 owing to the following factors:
GNPA levels are expected to surge high in 2016-17 as:

The asset quality review (AQR) initiative by the RBI will mount the NPA
Weak credit outlook for investment-led sectors continue
Corporate cash flows continue to be strained
Debt weighted credit ratio (ratio of upgrades to downgrades) have been declining
Some slippage is likely from loans restructured during the past 2-3 years, primarily from
the infrastructure (especially power) and construction sectors
Recoveries to reduce due to lower ARC sales

Public sector banks (PSBs) reported substantial high GNPAs at 9.4% as of March 2016 vis-avis 5% as of March 2015.Over the same period, the GNPAs of private banks were relatively
healthy at 2.8% as of March 2016 but private sector also felt the pain due to AQR initiative
by the RBI. The marked deterioration in the asset quality of PSBs can be attributed to the
weak monitoring and recovery mechanisms, slowdown in economic growth, sharp rise in
interest rates, and volatility in the currency and commodity markets. Sectors that mainly
contributed to higher NPAs were priority sectors (agriculture), construction, metals (iron and
steel), engineering, aviation and infrastructure (power and telecom).
Regulatory forbearance on loan restructuring ended on April 1, 2015. Post the sub-prime
crisis in 2008; the RBI allowed banks to restructure stressed assets while maintaining the
asset classification, i.e. the asset does not become non-performing as was the case earlier.
The special regulatory treatment helped banks limit the rise in GNPAs. Currently, banks
have to allocate lower provisions for standard restructured advances - 5%, compared with
Unnati Sector Report 2016-17 |48

Banking , Financial Services and Insurance


15% for sub-standard assets (the first level of NPAs - when interest or principal is due for
more than 90 days). As per the RBI's mandate, after April 2015, banks will have to treat all
restructured new standard advances as NPAs and make provisions accordingly. As 201415 was the last year for restructuring of loans, addition of such loans grew 7% despite being
at high levels in 2013-14. A weak economy led to a reduction in upgradation of restructured
loans and increased slippages of such loans into NPLs. Thus, the stock of standard
restructured loans for the sector rose 23% y-o-y to 5% of total loans. The sign of weakness in
restructured loans continued to play throughout 2015-16, and expected to remain under
pressure in 2016-17 unless economic growth improves sharply.
RBI in its Financial Stability Report (December 2015) was concerned specifically about the
mining, iron & steel, textiles, infrastructure and aviation sectors, which together constituted
nearly 24 per cent of the total advances of SCBs as of June 2015 and contributed to 53 per
cent of total stressed advances
Profitability
Higher NPAs imply lower income from the assets of the bank. This has to be accompanied by
the higher provisioning requirements, adding to the cost and thus reducing the profits of the
banks. This adversely affects the NIM and ROE of the banks.
The profitability of bank decreases not only by the amount of NPAs, but the opportunity cost of
these assets also affects the profitability. This is to say that if the banks were able to invest the
amount equal to the NPAs in some other return earning project/asset, they could earn profits. But
since the funds are blocked with the borrowers, banks cannot park these funds anywhere else. So
NPAs not only affect current profit but also future stream of profit, which may lead to loss of
some long-term beneficial opportunity.
Liquidity
Money gets blocked; decreased profit leads to lack of enough cash at hand which leads to
borrowing money for shortest period of time which leads to an additional cost to the company.
Difficulty in operating the functions of a bank due to lack of money is another impact of NPAs.
Involvement of management
Time and efforts of management is another indirect cost which bank has to bear due to NPAs.
Time and efforts of management in handling and managing NPAs would have diverted to some
fruitful activities, which would have given good returns. Nowadays banks have special
employees to deal and handle NPAs, which is an additional cost to the bank.
Public Sentiment

There is a definite loss of faith associated with the NPA numbers rising and this cannot be
compensated by larger profits. Banking is a business of Trust and this will greatly affect the
deposit growth and this is turn will affect the credit growth.

Unnati Sector Report 2016-17 |49

Banking , Financial Services and Insurance

Asset Reconstruction Company


The asset reconstruction companies or ARCs in India, which are in the business of buying bad
loans from banks and making money by recovering them, had aroundRs.50,000 crore worth of
bad assets under management in fiscal year 2015. Bank CEOs have started making
announcements on fresh packages of bad loans being put on sale, but the pace of sale is unlikely
to gather momentum. ARCs on however are not aggressively buying assets,and hence blame the
Reserve Bank of India (RBI) norms that have raised the minimum investment from 5% to 15% in
the so-called security receipts (SRs) or pass-through certificates that are issued against such
assets.
The ARCs levy higher discounts when they buy loans offering cash, but when they offer SRs for
buying loans, the discount drops
How do ARCs make money?
They get management fees of 1.5-2%. When the investment requirement rises three times, their
returns drop dramatically. Also, the fees are now linked to the net asset value (NAV) of the
assets and not the outstanding value of the SRs. So, any shortfall in the recovery of bad loans
lowers their fees. Six months after buying bad loans, the ARCs are required to get the SRs rated,
and based on the ratingwhich takes into account the progress in recoverythe NAV is
calculated.

From the ARCs point of view, cash transactions are always better as they can levy relatively
higher discounts, but they dont have the money to do so. Under norms, they can be 100% owned
by foreign investors who can lend money muscle and expertise, but none of them is entirely
foreign-owned and, in fact, very few have foreign stakes. They blame the 49% cap on single
holding for their failure to attract foreign investments. It is unlikely that RBI will allow a higher
foreign stake for a single investor as it believes that a widely held shareholding pattern ensures
corporate governance in a relatively lightly regulated sector.

Problem of Capitilsation.
Capital is the biggest problem for the ARCs. If indeed a fragmented ownership is coming in the
way to attract foreign capital, the ARCs should be allowed to tap the capital market by selling
shares to the public. Its not clear whether the Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest Act, which governs ARCs, allows them to do so. It
may not also be easy for them to raise money from public as legal issues remain the biggest
hurdle for the recovery of bad assets, leading to inordinate delays. Till the proposed bankruptcy
law is put in place, ARCs will struggle to recover and redeem SRs. There are other issues as
well. For instance, the stamp duty is not uniform in Indian states. This influences the pricing of
such assets.

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Banking , Financial Services and Insurance

Recent Trends (Analysis of Q1FY 2017)


Banking business showed mixed trends with deposits growing at a lower rate of 9.7% (y-o-y) in
Q1-FY17 compared with 10.7% in FY16. Growth in credit was however at a higher rate this
quarter at 9.4% as against 8.8% last year. There has however been limited progress on the
economic front in terms of industrial growth with this period witnessing an increase of just 0.6%
as against 3.3% last year.
The repo rate, which is the indicative rate fixed by the RBI had moved down by 75 bps during
this period. The deposit rate on tenure of 1-year for a select set of banks had moved down by
almost 100 bps during this period, while the base rate had been lowered by around 35 bps. Quite
clearly the response of banks was faster on deposits, which is a point highlighted by the RBI
often when talking on the transmission mechanism.
The RBI had introduced the system of MCLR (marginal cost of funds based lending rate) from
April onwards. Between April 1st and June end, the repo rate was lowered by 25 bps. Yet the
overnight MCLR changed marginally from a range of 8.95-9.15% to 8.9-9.15%.
Higher growth witnessed during this period is mainly in the non-manufacturing sector. Higher
growth in credit to sectors within manufacturing was witnessed in chemicals, metals (including
iron and steel), and construction. Growth on the whole for this sector was just about
positive at 0.6% compared with 4.8% last year.
The higher growth in credit to services was to NBFCs where they continued to borrow more for
on-lending purpose.
Commercial real estate also showed some buoyancy in this quarter.
Personal loans were the dominant segment registering growth of 18.5% growth in credit. There
was overall buoyancy in this segment with mortgages, auto loans and credit cards showing good
off take in credit during this period.
Banks too have been comfortable lending to this segment where the propensity for delinquency
is relatively lower than that of other sectors.
Analysis of a set of 39 banks for the first quarter reveals that banks have been under stress this
quarter and have been impacted by the quality of assets challenge. While banks have tended to
be circumspect when lending, their willingness to lower rates commensurate with the RBIs
actions has not been aggressive. The focus this quarter has been on cleaning up their books,
which is reflected in the accounts. Besides as mentioned earlier, demand for credit has been
relatively lower with industrial growth yet to takeoff and companies also preferring to use the
commercial paper route where typically the cost works out to be lower. Also typically this is the
slack season when demand for credit is low. Therefore, this has been, in a way, an ideal
environment to get into the act of cleaning up their balance sheets.
There was a marked slowdown in the interest income earned in this quarter from 8.1% last year
to 0.4% in FY17. For these banks, growth in advances was lower at 7% as against 9.6% last year
(this is as per accounts closing on June 30 and hence will be different from what was presented
earlier where the RBI provides data on the basis of the reporting fortnight).
Unnati Sector Report 2016-17 |51

Banking , Financial Services and Insurance

Lower growth in interest income was distinct for PSBs where it fell by 3.1% as against an
increase of 5.1% last year. Private Banks witnessed an increase of 10.7% which though lower
than that last year, was still fairly steady. Growth in interest income could be linked with both
the quantum of borrowing as well as interest rate movement, where there was some modicum of
stickiness witnessed in transmitting lower policy rates to borrowers. Growth in advances was
impressive for private banks which witnessed an increase of 19.1% while PCBs trailed at 3.3%.
The latter were more cautious while lending, while the private banks were more aggressive given
their proclivity to lend relatively more to the retail segment.
Another reason for lower growth in interest income would be concentration in lending in the
retail segment which is typically associated with relatively lower interest rates. Also as has
pointed out earlier, the base rate had not decreased in proportion to the average deposit rate. This
has helped banks show a better performance. In case the lending rates were also reduced
commensurately with deposit rates, the financials would have been affected more significantly.
Other income increased quite sharply which may be attributed to treasury gains. The decline in
the 10-years GSec by about 40-45 bps is indicative of the gains made by banks on this score. A
declining interest rate scenario is always viewed favorably by banks which are in a position to
sell a part of their portfolio for a profit.
Interest expenses of these banks declined by 0.9% in Q1-FY17 as against an increase of 7.6%
last year. This was due to a combination of both lower growth in deposits and decline in the
average deposit rate charged by banks.
On the expenditure side, growth in operating expenses was virtually stable at 13% which is
reflective of control over costs. This has become necessary at a time when top line growth is not
too stable.
A major pressure point however has been the sharp increase in provisioning mainly for NPAs
that also affected growth in PBT which declined sharply. Some banks, especially in the public
sector had to make higher provisions in a bid to clean up their balance sheets. Others were
pressurized by their move to shrink their balance sheets which in turn increased the NPA ratio.
These moves have been undertaken as part of the consolidation drive by banks to put their
accounts on stronger footing. It is expected that these NPAs will tend to decline in the next two
quarters.
For this quarter, the gross NPAs of banks had almost doubled (96%) with the ratio of gross
NPAs to advances increasing sharply from 4.6% to 8.5%. These high numbers were accounted
for by the PSBs which had witnessed 100% growth in NPAs and virtual doubling of the gross
NPA ratio from 5.3% to 10.4%. Private Banks were also pressurized with growth of 68% in
gross NPAs. But their NPAs ratio increased from 2.1% to 3%. Low growth in NII combined with
provisioning for NPAs did lead to a decline in the net profit of the sample banks for both the
years, which is disturbing. The fall was sharper for PSBs at 113% while there was a low positive
growth for private banks of 2.6% (11.1% last year).

Unnati Sector Report 2016-17 |52

Banking , Financial Services and Insurance


Profit issue is important for PSBs in the context of disinvestment at a later date which the
government is contemplating. High NPAs and low profitability would not augur well if the
government is working towards lowering its stake in these banks to 51%. It is hence positive for
this sector that the PSBs are aggressively making provisions for their NPAs and consolidating
their asset portfolio to be better prepared to face the market. Presently these sample banks appear
to be well capitalized with only 5 of the 39 banks falling short of 10% (Basel III) as of June 2016
with 4 being in the public sector.

Sector wise Bank credit in 2015-16


Credit Share
1.1
21.6

13.6

23.6

Food

Agriculture & Allied Activities Industry

39.9

Service

Personal Loans

Unnati Sector Report 2016-17 |53

Banking , Financial Services and Insurance

Priority Sector Lending:


Categories

Domestic scheduled commercial


banks and Foreign banks with 20
branches and above

Foreign banks with less


than 20 branches

Total Priority Sector

40 percent of Adjusted Net Bank


Credit* or Credit Equivalent Amount of
Off-Balance Sheet Exposure,
whichever is higher.

40 percent of Adjusted
Net Bank Credit or Credit
Equivalent Amount of
Off-Balance Sheet
Exposure, whichever is
higher; to be achieved in
a phased manner by 2020.

Foreign banks with 20 branches and


above have to achieve the Total Priority
Sector Target within a maximum
period of five years starting from April
1, 2013 and ending on March 31, 2018
as per the action plans submitted by
them and approved by RBI.
Agriculture #

18 percent of ANBC or Credit


Equivalent Amount of Off-Balance
Sheet Exposure, whichever is higher.

Not applicable

Within the 18 percent target for


agriculture, a target of 8 percent of
ANBC or Credit Equivalent Amount of
Off-Balance Sheet Exposure,
whichever is higher is prescribed for
Small and Marginal Farmers, to be
achieved in a phased manner i.e., 7 per
cent by March 2016 and 8 per cent by
March 2017.

Unnati Sector Report 2016-17 |54

Banking , Financial Services and Insurance

Micro Enterprises

Foreign banks with 20 branches and


above have to achieve the Agriculture
Target within a maximum period of
five years starting from April 1, 2013
and ending on March 31, 2018 as per
the action plans submitted by them and
approved by RBI. The sub-target for
Small and Marginal farmers would be
made applicable post 2018 after a
review in 2017.
7.5 percent of ANBC or Credit
Equivalent Amount of Off-Balance
Sheet Exposure, whichever is higher to
be achieved in a phased manner i.e. 7
per cent by March 2016 and 7.5 per
cent by March 2017.

Not Applicable

The sub-target for Micro Enterprises


for foreign banks with 20 branches and
above would be made applicable post
2018 after a review in 2017.
Advances to Weaker
Sections

10 percent of ANBC or Credit


Equivalent Amount of Off-Balance
Sheet Exposure, whichever is higher.

Not Applicable

Foreign banks with 20 branches and


above have to achieve the Weaker
Sections Target within a maximum
period of five years starting from April
1, 2013 and ending on March 31, 2018
as per the action plans submitted by
them and approved by RBI.

# Domestic banks have been directed to ensure that their overall direct lending to non-corporate
farmers does not fall below the system-wide average of the last three years achievement.

*Adjusted Net Bank Credit= Total bank credit + Investment in held-till maturity instruments bills rediscounted by RBI.

Unnati Sector Report 2016-17 |55

Banking , Financial Services and Insurance

Analysis of a Banking Stock:


How to analyse a Bank? How to pick up a correct Banking stock ?
To start off with, unlike any other manufacturing or service company, a bank's accounts are
presented in a different manner (as per banking regulations). The analysis of a bank account
differs significantly from any other company. The key operating and financial ratios, which one
would normally evaluate before investing in company, may not hold true for a bank.
So the details of a Banks balance sheet and Profit and Loss account is mentioned below:
The Balance Sheet of a bank
A banks balance sheet summarizes its assets and liabilities at any point of time. These terms are
explained below with respect to a bank's balance sheet.
Capital and Liabilities
These include the Banks net worth and the obligations of the bank to external entities. These
include:
1. Share Capital and Reserves and Surplus: Share capital includes the money invested by the
owners, or shareholders of the bank raised by way of IPO, private placements or other routes.
Reserves and Surplus include net profit transferred to the balance sheet, Statutory Reserve,
Securities premium, Currency Fluctuation Reserve etc.
2. Deposits: There are four types of deposit accounts, these are:
a) Demand Deposits: The deposits that are subject to withdrawal on demand of the depositor.
Demand deposits are cheap sources of funds for the banks, though comparatively less stable than
their counterpart. These may be of two types:
I. Current deposits: These are mainly used by businesses and have very frequent deposits and
withdrawals. These accounts have no minimum balance requirement or limit on the number of
withdrawals. No interest is paid on these accounts. Also, banks generally provide the facility of
overdraft to businesses having current accounts with them. These accounts are usually operated
by means of check books.
II. Savings deposits: These are the accounts that usually individuals have with the bank. They
have minimum balance requirements and a cap on the maximum number of withdrawals per
month. The interest is payable by the banks, calculated on a daily basis. The interest rate was
earlier fixed by RBI at 4% per annum, but was de-regulated in 2011 allowing banks to give
higher rates of interest. These accounts can also issue check books for transactions.

b) Term Deposits: They are not payable by the banks on demand. Depositors need to give prior
notice to the banks for withdrawal, and there are penalties imposed on withdrawal before the
maturity of the deposit. Though more expensive in terms of interest payable, term deposits are a
more stable source of fund for the banks. These are of two types:
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Banking , Financial Services and Insurance


I. Fixed Deposits: A lump sum amount is deposited with the banks for a fixed tenure. Banks
give very high rates of interest on fixed deposits when compared to the demand deposits.
II. Recurring Deposits: These deposits provide the benefit of fixed deposits to those who
cannot pay a lump sum amount, but can save regularly. Individuals deposit a fixed amount every
month and get interests very similar to those in case of FDs.
3. Borrowings: In order to meet their obligations, banks also raise money through wholesale
money market. This includes funds borrowed from RBI or market instruments such as
debentures, bonds, certificate of deposits, commercial papers and short term borrowings from
other banks and financial institutions. The cost of wholesale funding is generally high but banks
raise money through this method when they are unable to get them through deposits which are a
cheaper option. Banks may also raise funds from overseas debt market to take advantage of low
interest rates.
4. Other Liabilities and provisions: These include bills payable, interest accrued, contingent
provisions against standard assets and proposed dividend (including tax on dividend).

Assets
An asset is a resource that leads to a future inflow of economic benefits. For a bank, assets
include:
1. Cash and balances with RBI: Along with the cash held at the branches, banks are also
required to keep a certain amount of cash with the RBI. This is given by the CRR (Cash Reserve
Ratio), which are currently 4% of the net demand and time liabilities of the banks.
2. Government Bonds and other approved Securities: It is a statutory requirement that every
bank in India has to maintain a certain percentage of its deposits in the form of gold or approved
securities with the RBI. This requirement is known as statutory liquidity ratio (SLR).
3. Loans and advances: Loan refers to the money which is lent to a borrower by a bank. Banks
charge interest on loans, which forms the primary source of income for them. Approximately
70% of the assets of a bank are in the form of loans and advances. Loans may be short term/long
term and secured/unsecured. The major types of loans that banks offer are:
a. Commercial and industrial loans
b. Real Estate Loans
c. Consumer loans
d. Interbank loans

4. Fixed Assets: These include office buildings (if owned), furniture, computers and other items
such as ATM machines. However, it constitutes a very small part of assets for a bank because
most of its branches run on rent/lease.
5. Other assets: These include investments made by banks and can be a source of income for the
bank.

Unnati Sector Report 2016-17 |57

Banking , Financial Services and Insurance


Common Size Balance sheet for SBI and YES Bank as on 31st March 2016
201516
Particulars
Share Capital
Reserve and surplus
Deposits
Borrowings
Other liabilities and provision
Total

Asset
Cash and Balance with RBI
Balance with banks and money
market at call and short notice
Investments(Includes
government bonds and approved
securities)
Advances
Fixed Assets
Other assets
Total

201415

YES Bank
0.250.31
8.078.26
67.6066.96
19.1619.26
4.915.21
100.00 100.00

Change
(%)
0.67
18.62
22.54
20.74
14.35
21.37

2015-20141615
State Bank of
India
0.030.03
6.075.96
76.0276.19
8.719.08
9.178.74
100.00 100.00

3.50

3.85

10.22

5.40

5.34

11.18

1.48

1.70

5.44

1.47

1.64

-1.04

29.53
59.43
0.29
5.78
100.00

31.73
55.49
0.24
6.99
100.00

12.95
29.99
47.45
0.32
21.37

23.74
62.95
0.51
5.93
100.00

24.94
62.67
0.46
4.95
100.00

4.70
10.52
23.23
31.83
10.03

Change
(%)
3.98
11.94
9.79
5.54
15.43
10.02

Income Statement
This is the banks Profit and Loss account, the various elements of which are given as:
1. Interest Income: The primary income of the bank comes from this category. This includes the
interest earned on loans and advances. This also includes interest on loans given to other
financial institutions and banks and deposits with the RBI, and any interest earned on bonds
which the bank owns.
2. Non-Interest Income: This is income primarily derived from fees which the bank charges.
This includes deposit and transaction fees, annual fees (for services like credit cards), brokerage
fees etc. Non-Interest income is a less volatile form of income since it does not depend as much
on interest rate changes as interest income. A higher proportion leads to more stable earnings.
3. Interest Expense: This represents the interest paid by a bank on deposits, wholesale
borrowings, and loans taken from RBI or from other financial institutions.
4. Operating Expense: This includes expenses which are incurred in running the day to day
operations of the bank, namely costs like salaries, rent, depreciation, advertising etc.

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5. Provisions: Since not each and every loan will be paid back in full, banks have to make
provisions for these loans. Banks thus set aside a percentage of their income to account for these
possible losses. This ensures that the bank remains solvent and there are no sudden unexpected
huge losses to the bank. The amount set aside for provisioning depends on the size of a bank's
assets and the risk associated with each type of asset. The norms for provisioning are decided by
the RBI.
Common Size Profit and Loss for SBI and YES Bank
2015-16
Particulars
Revenue
Interest Income
Other Income
Total Revenue
Expenditure
Interest Expended
Operating Expenses

YES Bank
%
83
17
100
%
55
18

Provisionand
Contingency(Including 11
Provision for tax)
16Net Profit

2014-15

2015-16

2014-15

%
85
15
100
%
59
17

Change
(%)
%
17
33
19
%
11
31

State Bank of India


%%
8181
1919
100100
%%
5252
2728

Change(%)
%
7
3
6
%
7
1

42

16

13

30

15

27

-27

Specific Ratios for a Bank:


1.NII (Net Interest Income): Net Interest Income is simply the difference between interest
earned by the bank on its assets, i.e. loans and investments and interest paid by the bank on its
borrowings. This is the major source of profit to the bank. However, being an absolute measure,
it cannot be used to compare the performance of different banks.

2. NIM (Net Interest Margin): NIM is used to measure the profitability of the banks and is a
major parameter used to compare the performance of different banks. It is defined as the
difference between the interest income and interest expense (NII) relative to the average interest
bearing assets of the bank.

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3. Operating Profit Margin (OPM): This is the operating profit, i.e. NII minus the operating
expenses, relative to total interest income. Higher OPM indicates lower interest or operating
expenses in relation to interest income.

4. Cost to Income: This is the ratio of operating cost to total income. It measures the efficiency
with which bank is able to generate income. It is calculated as:-

Other Income to Total Income: Other income mainly consists of fees and commission. This
income is not dependent directly on the assets of the bank and has huge potential to add to the
profits of the bank even during low loan demand.
Other Income to Total Income = Other Income /Total Income
6. CASA Ratio: CASA or Current and Savings Account Ratio are the ratio of current and
savings deposits of a bank to its total deposits. As discussed earlier, banks pay less interest on the
current and savings accounts as compared to interest on term deposits. In another words, current
and savings deposits are a cheaper source of funds for the banks. Hence, a high CASA ratio
suggests availability of cheaper funds, leading to increased operational efficiency and thus higher
profits. However, demand deposits (CASA) can be withdrawn at any time by the depositors
leading to fluctuations in liquidity. So, banks also need a sufficient amount of term deposits to
fund the long term loans and avoid asset-liability mismatch.
CASA Ratio = (Current Deposits + Savings Deposits) /Total Deposits
7. Credit to Deposit Ratio: This ratio helps assess a banks liquidity. A very high C/D ratio
makes the bank vulnerable to adverse changes in its deposit base. Conversely, a low C/D ratio
indicates holding unproductive capital and lower than optimum earnings.
Credit to Deposit Ratio = Total Credit /Total Deposits
8. CAR (Capital Adequacy Ratio): It is the ratio of the banks capital to its risk weighted
assets. CAR is used to determine the ability of banks to absorb some reasonable amount of loss
without facing the risk of bankruptcy. The higher the CAR of a bank the better capitalized it is.
The current mandatory CAR in India is 9%. The ratio is to be gradually increased to 11.5% by
March 31, 2019 to align Indian standards with the Basel III norms. It is calculated as:-

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Tier I Capital: This is the core capital of the bank. It primarily consists of common stock and
retained earnings of the bank. It may also include non-redeemable non-cumulative preferred
stock. Tier I items are deemed to be of the highest quality because they are fully available to
cover losses.
Tier II Capital: This is the supplement capital of the bank. It includes undisclosed reserves,
revaluation reserves and general provisions. Tier II's capital loss absorption capacity is lower
than that of Tier I capital.
Risk Weighted Assets (RWA): These are the assets of the bank weighted according to the risk
associated with them. This risk has been defined by the RBI for different types of securities,
investments and loans and ranges between 0 and 150%. For example, RBI has given risk weight
of 150 to investments in venture capital funds whereas loans guaranteed by the Government of
India have been given risk weight of 0%.
9. Classification of Assets
a) Standard Assets: Assets which do not disclose any problem and do not carry more than the
normal risk attached to the business. Such assets are not non-performing assets.
b) NPA (Non-Performing Assets): The definition of NPA as given by RBI is an asset, which
ceases to generate income for a bank. Hence it is a loan, the payment of which is unlikely to be
received. Any loan is recognized as NPA only when the receipt of payment for it 'remains due'
for a specified period of time.
A NPA is a loan or advance where:a) Interest or installment remains overdue for over 90 days in case of a term loan
b) The account remains 'out of order' in case of overdraft/cash credit facility. A current account is
treated as 'out of order' if outstanding balance is in excess of sanctioned limits or when it is
within sanctioned limits and there are no credits for 90 days or are not enough to cover the
charges for interest debited.
c) The bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted.
d) Agricultural loans are classified as NPAs, if, for short duration crops, installment of principal
or interest remains overdue for one crop seasons; for long duration crops, this period is taken to
be two crop season.
e) In case of derivative and liquidity transactions, if the dues for these remain unpaid for 90 days.

According to norms, any income received from NPAs is recorded only when it is received.
Banks are required to classify non-performing assets further into the following three categories
based on the period for which the asset has remained non-performing and the expected
realization of the dues:Sub-standard assets: A sub-standard asset would be one, which has remained NPA for a period
less than or equal to 12 months. Such an asset will have well defined credit weaknesses that
jeopardize the liquidation of the debt and is characterized by the distinct possibility that the

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banks will sustain some loss, if deficiencies are not corrected. All the restructured loans will also
be classified as Sub-standard assets from 1st April, 2015.
Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard
category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent
in assets that were classified as sub-standard, with the added characteristic that the weaknesses
make collection or liquidation in full - on the basis of currently known facts, conditions and
values - highly questionable and improbable.
Loss assets: An asset would be considered as a loss asset if loss has been identified by the bank
or by internal / external auditors or by RBI inspection, but the amount has not been written off,
wholly or in part. Such assets are considered uncollectible and of so little value that their
continuance as bankable assets is not warranted, even though there may be some salvage or
recovery value.
NPAs are calculated in two ways:
GNPA: Gross NPAs are the total amount of loans that the bank cannot recover from the
borrowers.
NNPA: Net NPAs are GNPAs minus the provisions made against them, i.e. total NPAs less the
expected non-recovery recorded in the books.
Banks are required to maintain provisions for these NPAs. Provisioning Norms are as follows:

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Provisioning Coverage Ratio: As per RBI, Provisioning Coverage Ratio (PCR) is essentially
the ratio of provisioning to gross non-performing assets and indicates the extent of funds a bank
has kept aside to cover loan losses. From a macro-prudential perspective, banks should build up
provisioning and capital buffers in good times i.e. when the profits are good, which can be used
for absorbing losses in a downturn. This will enhance the soundness of individual banks, as also
the stability of the financial sector. RBI thus requires banks to ensure that their total provisioning
coverage ratio is not less than 70 per cent.
Provisioning Coverage Ratio = Amount of Total Provision for NPAs /GNPA
Financial Information for SBI and Yes Bank
Parameters
Current Price
Book Value
Price/BV
ROE%
ROA%
EPS
Cost of Funds
Net Interest Margin
Deposits(in Mn)
Advances(in Mn)
Credit to Deposit Ratio
CASA to Deposits
Cost to income
Other Income as a
income(Q1F17)
CAR%
Tier 1
GNPA
NNPA
PCR

of

Yes Bank
1339
345.2
3.88
20.70%
1.70%
17.4
7%
3.40%
1225811
1059420
86.43
29.60%
41.10%

SBI
255
180
1.42
7.36%
0.44%
13.03
6.07%
2.83%
17823710
14164850
79.47
42.78%
48.94%

68.40
15.50
10.30
0.79%
0.29%
64.20%

17.63
14.01
10.82
9.14
5.5
54.67

Interest

Analyzing a Bank stock


There is no one method of how to analyse a bank, however the following checks will help us
understand how well a bank is placed in comparison with its peers. As investors we can get far
by focusing on four things:

What the bank actually does


Its price
Its earnings power
The amount of risk it's taking to achieve that earnings power
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What the bank actually does?
When we read through a bank's earnings releases, it's easy to get sidetracked by management's
promises -- as every bank says it's customer-focused and a conservative lender. In banking, the
assets are the loans the banks make, the securities the banks hold, etc. They're the things that will
drive future profitability when they're chosen carefully, and they're the things that will force the
bank to fail (or get bailed out) when the Bank gets in trouble.
Loans are the heart of a traditional bank, the greater a bank's loans as a percentage of assets, the
closer it is to a prototypical bank. If a bank isn't holding loans, it's most likely holding securities.
For example, its business model may not be loan-driven, it may be losing loan business to other
banks, or it may just be being conservative when it can't find favorable loan terms. In any case,
looking at loans as a percentage of assets gives us questions to explore deeper. The next step of
digging into the loans is looking at what types of loans a bank makes.
Looking into the common size balance sheet of Yes bank and State Bank of India, we can see
that the increase in advances for Yes Bank has been almost 3 times that of State Bank of India
for FY 2015-16. Further probing deeper it can be found out that the retail advances form 32.5%
of the total advances as compared to around 20% for State Bank of India. This has made the loan
book of Yes Bank more granular, thus leading to improve in credit quality as compared to SBI
which is plagued by NPAs in the corporate and Mid Corporate group.
The one-line summary: On the assets side, look at the loans.
Just as the loans tell the story on the assets side, the deposits tell the story on the liabilities
side. The prototypical bank takes in deposits and makes loans, so two ratios help get a feel for
how prototypical your bank is: 1) Deposits/Liabilities 2) Loans/Deposits.
Deposits are great for banks as they have to pay low interest rates on savings and current
accounts. Via these deposit accounts, you're essentially lending the bank money cheaply. If a
bank can't attract a lot of deposits, it has to take on debt (or issue stock on the equity side), which
is generally much more expensive. That can lead to risky lending behavior -- i.e. chasing yields
to justify the costs. All of this confirms what we suspected after looking at the loans on the asset
side (Breakup of Loan category)
CASA deposits are low cost funds and having a high percentage of deposits in the form of
CASA reduces the overall cost of funds. The CASA deposits are very high for SBI owing to its
widespread reach and penetration; it is as high as 42.78% as compared to around 29% for Yes
Bank.
Now looking at the Profit and Loss side,
The big thing to focus on here is the two different types of bank income: net interest income and
noninterest income.
At its core, a bank makes money by borrowing at one rate (via deposits and debt) and lending at
another higher rate (via loans and securities). Well, net interest income measures that profit.

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Meanwhile, noninterest income is the money the bank makes from everything else, such as fees
on mortgages, fees and penalties on credit cards, charges on checking and savings accounts, and
fees on services like investment advice for individuals and corporate banking for businesses.
The noninterest income can smooth interest rate volatility but it can also be a risk if regulators
change the rules.
Other income for Yes Bank for Q1F17 was very high at 68.40% as compared to around 17% for
SBI, owing to increase in corporate fees for YES Bank. This has helped Yes Bank earn high Fee
income and hence reduce dependence on only interest income. This is the reason majority of the
banks today are focusing on increasing their Non Interest income.
Price:
The oversimplified saying in banking is "buy at half of book value; sell at two times book value."
Book value is just another way of saying Net worth. If a bank is selling at book value that means
you're buying it at a price equal to its net worth (i.e. its assets minus its liabilities).
To get a little more conservative and advanced than price/book ratio, we can look at the
price/tangible book ratio. As its name implies, this ratio goes a step further and strips out a bank's
intangible assets, such as goodwill. A bank that wildly overpays to buy another bank would add a
bunch of goodwill to its assets -- and boost its equity. By refusing to give credit to that goodwill,
we're being more conservative in what we consider a real asset. Hence, the price-to-tangible
book value will always be at least as high as the price-to-book ratio.
From the P/B ratio, SBI has a lower valuation at 1.42 times as compared to Yes Bank at 3.88
times
Earning Power:
Return on equity shows you how well a bank turns its equity into earnings. Equity's ultimately
not very useful if it can't be used to make earnings.
Breaking earnings power down further, you can look at net interest margin and efficiency.
Net interest margin measures how profitably a bank is making investments. It takes the interest a
bank makes on its loans and securities, subtracts out the interest it pays on deposits and debt, and
divides it all over the value of those loans and securities.
Yes bank enjoys a higher NIM at 3.40% as compared to SBI at 2.83%
While net interest margin gives you a feel for how well a bank is doing on the interest-generating
side, a bank's efficiency ratio, as its name suggests, gives you a feel for how efficiently it's
running its operations.
The efficiency ratio takes the non-interest expenses (salaries, building costs, technology, etc.)
and divides them into revenue. So, the lower the better.

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There are nuances in all this, of course. For instance, a bank may have an unfavorable efficiency
ratio because it is investing to create a better customer service atmosphere as part of its strategy
to boost revenues and expand net interest margins over the long term.
Meanwhile, ROE and net interest margins can be juiced by taking more risk.
The amount of risk it's taking to achieve that earnings power
There are a lot of ratios that try to measure how risky a bank's balance sheet is.

Tier 1 common ratio


Common equity tier 1 ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Tier 1 leverage ratio.
A much simpler ratio: Assets/equity.

This ratio tells us our capital adequacy; the NPAs that are written off are from the equity of the
Bank. So if bank does not have enough equity , it will fall short of capital to write off NPAs and
thus causing the Banks to fail or get bailed out.
We can get more complicated by using tangible equity, but this is a good basic leverage ratio to
check out.That leverage ratio gives us a good high-level footing. Getting deeper into assessing assets,
we need to look at the strength of the loans. Let's focus on two metrics for this:

Bad loan percentage (Non-performing Loans/Total Loans)


Coverage of bad loans (Allowance for non-performing loans/Non-performing loans)
Non-performing loans are loans that are behind on payment for a certain period of time (90 days
is usually the threshold).
Like most of these metrics, it really depends on the economic environment for what a reasonable
bad loan percentage is. During the housing crash, bad loan percentages above five percent
weren't uncommon.
Banks know that not every loan will get paid back, so they take an earnings hit early and
establish an allowance for bad loans. Banks can boost their current earnings by not provisioning
enough for loans that will eventually default. So a check on the provisioning norms also has to be
kept in mind while analyzing a bank.
From the risk side, both SBI and Yes Bank have very good Capital adequacy ratio. For SBI the
capital infusion by the government has helped the cause. But the point of concern here is the
extremely High NPAs for SBI and on the other hand YES Bank looks more lucrative at a
minimal NPA level of under 1%.
So Overall Yes Bank has a fundamentally better situation than State Bank of India.
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Insurance:
Insurance is a hedging mechanism wherein a large number of parties come together to share risk
by the pooling of resources. All the parties involved in pooling pay a certain amount of money or
premium to a third party called the insurer. The amount of premium paid is commensurate with
the risk involved and the value of the asset insured. This collective risk bearing is called
insurance.
Classification:
Life Insurance: Life insurance is an insurance coverage that pays out a certain amount of money
to the insured or their specified beneficiaries upon death of the individual who is insured or
maturity of the policy, whichever is earlier. It not only ensures financial security for the family
members of the insured in case of his death, but also provides attractive investment and tax
benefit options. Within life insurance a large number of options are also available and any
potential customer has the flexibility to choose from them based on his requirements and
priorities.
General Insurance: General insurance covers insurance policies other than life insurance. This
is for insuring property, such as vehicle, stock etc. against some unforeseen events which result
in a financial loss for the insured. It provides compensation to the individual in case of losses, to
the extent of the loss suffered by the individual. It also includes health insurance, covering the
risk of large bills of medical treatments.
Re Insurance: It is the insurance that is purchased by an insurance company to mitigate some of
the risks associated with its insurance business.
Bank Insurance Model or Bancassurance
Bancassurance is the selling of insurance and banking products through the same channel, most
commonly through bank branches. Selling insurance. Means distribution of insurance and other
financial products through Banks.
The following factors have mainly led to success of
bancassurance
Pressure on banks' profit margins. Bancassurance offers another area of profitability to
banks with little or no capital outlay. A small capital outlay in turn means a high return on
equity.
A desire to provide one-stop customer service. Today, convenience is a major issue in
managing a person's day to day activities. A bank, which is able to market insurance
products, has a competitive edge over its competitors. It can provide complete financial
planning services to its customers under one roof.
Opportunities for sophisticated product offerings.
Opportunities for greater customer lifecycle management.
Diversify and grow revenue base from existing relationships.

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Diversify risks by tapping another area of profitability.


The realisation that insurance is a necessary consumer need. Banks can use their large
base
of existing customers to sell insurance products.
Bank aims to increase percentage of non-interest fee income
Cost effective use of premises

Disadvantages:

Data management of an individual customers identity and contact details may result in the
insurance company utilizing the details to market their products, thus compromising on data
security.
There is a possibility of conflict of interest between the other products of bank and insurance
policies (like money back policy). This could confuse the customer regarding where he has to
invest.
Better approach and services provided by banks to customer is a hope rather than a fact. This
is because many banks in India are known for their bad customer service and this fact turns
worse when they are responsible to sell insurance products. Work nature to market insurance
products require submissive attitude, which is a point that has to be worked on by many
banks in India.

Overview of the insurance sector in India

Market share for insurance companies are reported in two ways:


1. Based on the number of policies.
2. Based on first year premiums income.

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The largest insurance companies in India terms of market share based on total insurance
premium collected are:LIC
ICICI Prudential
HDFC Standard
SBI Life
Bajaj Allianz
Max Life
Birla Sunlife

SPECIALISED INSURERS
Export Credit Guarantee Corporation of India Limited: Export Credit Guarantee Corporation of
India Ltd (ECGC) is a specialised insurer underwriting business in export credit insurance.
Agriculture Insurance Company of India Ltd: Agriculture Insurance Company of India Ltd (AIC)
is a specialised insurer underwriting business in agriculture insurance.
Stand Alone Health Insurance Companies: IRDA as on 31st March, 2014 has granted licenses
to five insurance companies to operate as standalone health insurance companies. They are: Star
Health and Allied Insurance Co. Ltd., Apollo Munich Health Insurance Co. Ltd., Max Bupa
Health Insurance Co. Ltd., Religare Health Insurance Co. Ltd. and Cigna TTK Health Insurance
Company Limited. These insurance companies are authorized to underwrite business in health,
personal accident and travel insurance segments.

Performance of the sector:


During April 2015 to March 2016 period, the life insurance industry recorded a new premium
income of Rs 1.38 trillion (US$ 20.54 billion), indicating a growth rate of 22.5 per cent. The
general insurance industry recorded a 12 per cent growth in Gross Direct Premium underwritten
in April 2016 at Rs 105.25 billion (US$ 1.55 billion).
India life insurance sector is the biggest in the world with about 360 million policies which are
expected to increase at a Compound Annual Growth Rate (CAGR) of 12-15 per cent over the
next five years. The insurance industry plans to hike penetration levels to five per cent by 2020.
The countrys insurance market is expected to quadruple in size over the next 10 years from its
current size of US$ 60 billion. During this period, the life insurance market is slated to cross US$
160 billion.
The general insurance business in India is currently at Rs 78,000 crore (US$ 11.44 billion)
premium per annum industry and is growing at a healthy rate of 17 per cent.
The Indian insurance market is a huge business opportunity waiting to be harnessed. India
currently accounts for less than 1.5 per cent of the worlds total insurance premiums and about 2
per cent of the worlds life insurance premiums despite being the second most populous
nation. The country is the fifteenth largest insurance market in the world in terms of premium
volume, and has the potential to grow exponentially in the coming year.
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Trends in the sector
Increasing Private sector activity in the insurance sector: Share of private sector has been
growing over the years, from around 2 per cent in FY03 to 25 per cent in FY15 between FY0414.The total number of life insurance companies increased from 5373 in FY07 to 11032 in
FY14.

Increasing penetration and density of the life insurance over the years: Insurance density in India
increased from 3.57 in FY05 to 11.23 in FY15 at a CAGR of 12.1 per cent. Insurance penetration
reached 3.3 per cent in FY15.

LIC continues to be the Market Leader


In 2015, the life insurance sector has 29* private players, compared to only four in FY02
LIC is still the market leader, with 69 per cent share in FY15, followed by ICICI Prudential; with
6.0 per cent share.LIC issued 20.1 million new policies in FY15

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Strong growth in the Non Life sector
The non-life insurance market grew from USD2.6 billion in FY02 to USD13.9 billion in FY15
Over FY0215, non-life insurance premiums increased at a CAGR of 13.8 per cent. The number
of policies issued increased from 43.6 million in FY03 to 126 million in FY15, at a CAGR of 9.2
per cent.
Motor Insurance leads the Non Life sector
Motor insurance accounted for 39.41 per cent of the gross direct premiums earned in FY16 (up
from 41 per cent in FY06), at USD1.01 billion. At USD0.71 billion, the health segment seized
27.75 per cent share in gross direct premiums Private players contributes around 50.2 per cent in
the total revenue generated in non life insurance sector while public companies contributes
around 49.8 per cent share.
Major private players are ICICI Lombard, Bajaj Allianz,IFFCO Tokio, HDFC Ergo, Tata-AIG,
Reliance,Cholamandalam, Royal Sundaram and other regional insurers
Investments
The following are some of the major investments and developments in the Indian insurance
sector.

The Insurance Regulatory and Development Authority of India (IRDAI) plans to issue
redesigned initial public offering (IPO) guidelines for insurance companies in India, which
are to looking to divest equity through the IPO route.
Aviva Plc, the UK-based Insurance company, has acquired an additional 23 per cent stake in
Aviva Life Insurance Company India from the joint venture (JV) partner Dabur Invest
Corporation for Rs 940 crore (US$ 141.3 million), thereby increasing their stake to 49 per
cent in the company.
The Insurance sector in India is expected to attract over Rs 12,000 crore (US$ 1.76 billion) in
2016 as many foreign companies are expected to raise their stake in private sector insurance
joint ventures.
Quest Global, a pure-play engineering and Research and Development (R&D) services
provider, has raised investment of around Rs 2,396 crore (US$ 351.54 million) from leading
global investors Bain Capital, GIC and Advent International for a minority stake in the
company.
Insurance firm AIA Group Ltd has decided to increase its stake in Tata AIA Life Insurance
Co Ltd, a joint venture owned by Tata Sons Ltd and AIA Group from 26 per cent to 49 per
cent.
Canada-based Sun Life Financial Inc plans to increase its stake from 26 per cent to 49 per
cent in Birla Sun Life Insurance Co Ltd, a joint venture with Aditya Birla Nuvo Ltd, through
buying of shares worth Rs 1,664 crore (US$ 244.14 million).
Nippon Life Insurance, Japans second largest life insurance company, has signed definitive
agreements to invest Rs 2,265 crore (US$ 332.32 million) in order to increase its stake in
Reliance Life Insurance from 26 per cent to 49 per cent.

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Bennett Coleman and Co. Ltd (BCCL), the media conglomerate with multiple publications in
several languages across India, is set to buy Religare Enterprises Ltds entire 44 per cent
stake in life insurance joint venture Aegon Religare Life Insurance Co. Ltd. The foreign
partner Aegon is set to increase its stake in the joint venture from 26 per cent to 49 per cent,
following governments reform measure allowing the increase in stake holding by foreign
companies in the insurance sector.
GIC Re and 11 other non-life insurers have jointly formed the India Nuclear Insurance Pool
with a capacity of Rs 1,500 crore (US$ 220.08 million) and will provide the risk transfer
mechanism to the operators and suppliers under the CLND Act.
State Bank of India has announced that BNP Paribas Cardiff is keen to increase its stake in
SBI Life Insurance from 26 per cent to 36 per cent. Once the foreign joint venture partner
increases its stake to 36 per cent, SBIs stake in SBI Life will get diluted to 64 per cent

Government Initiatives
The Government of India has taken a number of initiatives to boost the insurance industry. Some
of them are as follows:
The Union Budget of 2016-17 has made the following provisions for the Insurance
Sector:

Foreign investment will be allowed through automatic route for up to 49 per cent subject to
the guidelines on Indian management and control, to be verified by the regulators.
Service tax on single premium annuity policies has been reduced from 3.5 per cent to 1.4 per
cent of the premium paid in certain cases.
Government insurance companies to be listed on the exchanges
Service tax on service of life insurance business provided by way of annuity under the
National Pension System regulated by Pension Fund Regulatory and Development Authority
(PFRDA) being exempted, with effect from April 01, 2016.
The Insurance Regulatory and Development Authority (IRDA) of India has formed two
committees to explore and suggest ways to promote e-commerce in the sector in order to
increase insurance penetration and bring financial inclusion.
IRDA has formulated a draft regulation, IRDAI (Obligations of Insures to Rural and Social
Sectors) Regulations, 2015, in pursuance of the amendments brought about under section 32
B of the Insurance Laws (Amendment) Act, 2015. These regulations impose obligations on
insurers towards providing insurance cover to the rural and economically weaker sections of
the population.
The Government of India has launched two insurance schemes as announced in Union
Budget 2015-16. The first is Pradhan Mantri Suraksha Bima Yojana (PMSBY), which is a
Personal Accident Insurance Scheme. The second is Pradhan Mantri Jeevan Jyoti Bima
Yojana (PMJJBY), which is the governments Life Insurance Scheme. Both the schemes
offer basic insurance at minimal rates and can be easily availed of through various
government agencies and private sector outlets.

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The Uttar Pradesh government has launched a first of its kind banking and insurance services
helpline for farmers where individuals can lodge their complaints on a toll free number.
The select committee of the Rajya Sabha gave its approval to increase stake of foreign
investors to 49 per cent equity investment in insurance companies.
Government of India has launched an insurance pool to the tune of Rs 1,500 crore (US$
220.08 million) which is mandatory under the Civil Liability for Nuclear Damage Act
(CLND) in a bid to offset financial burden of foreign nuclear suppliers.
Foreign Investment Promotion Board (FIPB) has cleared 15 Foreign Direct Investment (FDI)
proposals including large investments in the insurance sector by Nippon Life Insurance, AIA
International, Sun Life and Aviva Life leading to a cumulative investment of Rs 7,262 crore
(US$ 1.09 billion).
The Insurance Regulatory and Development Authority of India (IRDAI) has given initial
approval to open branches in India to Switzerland, French and Germany-based reinsurers
namely, Hannover Re and Munich Re.

Road Ahead
The Indian insurance industry is expected to grow to US$ 280 billion by FY2020, owing to the
solid economic growth and higher personal disposable incomes in the country.
There are 24 life insurance and 28 non-life insurance companies in the Indian market who
compete on price and services to attract customers. The industry has been spurred by product
innovation, vibrant distribution channels, coupled with targeted publicity and promotional
campaigns by the insurers. Government has approved the ordinance to increase Foreign Direct
Investment (FDI) limit in Insurance sector from 26 per cent to 49 per cent which would further
help attract investments in the sector.
The Insurance Regulatory and Development Authority (IRDA) recently allowed life insurance
companies that have completed 10 years of operations to raise capital through Initial Public
Offerings (IPOs). Insurance products are also covered under the ExemptExemptExempt (EEE)
method of taxation, which translates to an effective tax benefit of approximately 30 per cent on
select investments. In 2015, Government introduced Pradhan Mantri Suraksha Bima Yojna
(PMSBY) and Pradhan Mantri Jeevan Jyoti Bima Yojana (PMJBY) to bring more people under
the insurance cover.
Going forward, increasing life expectancy, favourable savings and greater employment in the
private sector is expected to fuel demand for pension plans. Likewise, strong growth in the
automotive industry over the next decade would be a key driver for the motor insurance market.

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Non-Banking Financial Companies (NBFC)


Non-banking finance companies (NBFCs) form an integral part of the Indian financial system.
They play an important role in nation building and financial inclusion by complementing the
banking sector in reaching out credit to the unbanked segments of society, especially to the
micro, small and medium enterprises (MSMEs), which form the cradle of entrepreneurship and
innovation. NBFCs ground-level understanding of their customers profile and their credit needs
gives them an edge, as does their ability to innovate and customise products as per their clients
needs. This makes them the perfect conduit for delivering credit to MSMEs. However, NBFCs
operate under certain regulatory constraints, which put them at a disadvantage vis--vis banks.
While there has been a regulatory convergence between banks and NBFCs on the asset side, on
the liability side, NBFCs still do not enjoy a level playing field. This needs to be addressed to
help NBFCs realise their full potential and thereby perform their duties with greater efficiency.
Moreover, with the banking system clearly constrained in terms of expanding their lending
activities, the role of NBFCs becomes even more important now, especially when the
government has a strong focus on promoting entrepreneurship so that India can emerge as a
country of job creators instead of being one of job seekers. Innovation and diversification are the
important contributors to achieve the desired objectives.

NBFCs lend and make investments and hence their activities are akin to that of banks; however
there are a few differences as given below:
1. NBFC cannot accept demand deposits
2. NBFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on them
3. Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of NBFCs, unlike in case of banks
Factors contributing to the growth of NBFCs:

Stress on public sector units (PSUs)


Latent credit demand
Digital disruption, especially for micro, small and medium enterprises (MSMEs) and small
and medium enterprises (SMEs)
Increased consumption
Distribution reach and sectors where traditional banks do not lend

The NBFC sector in India


NBFCs are categorized
a) In terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs,
b) Non deposit taking NBFCs by their size into systemically important and other non-deposit
holding companies (NBFC-NDSI and NBFC-ND) and
c) By the kind of activity they conduct.
Within this broad categorization the different types of NBFCs are as follows:

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Asset Finance Company(AFC) : An AFC is a company which is a financial institution carrying
on as its principal business the financing of physical assets supporting productive/economic
activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material
handling equipments, moving on own power and general purpose industrial machines. Principal
business for this purpose is defined as aggregate of financing real/physical assets supporting
economic activity and income arising there from is not less than 60% of its total assets and total
income respectively
Investment Company (IC): IC means any company which is a financial institution carrying on
as its principal business the acquisition of securities
Loan Company (LC): LC means any company which is a financial institution carrying on as its
principal business the providing of finance whether by making loans or advances or otherwise
for any activity other than its own but does not include an Asset Finance Company
Infrastructure Finance Company (IFC): IFC is a non-banking finance company a) which deploys
at least 75 per cent of its total assets in infrastructure loans, b) has a minimum Net Owned Funds
of Rs.300 crore, c) has a minimum credit rating of A or equivalent d) and a CRAR of 15%.
Systemically Important Core Investment Company (CIC-ND-SI): CIC-ND-SI is an NBFC
carrying on the business of acquisition of shares and securities which satisfies the following
conditions:-

It holds not less than 90% of its Total Assets in the form of investment in equity shares,
preference shares, debt or loans in group companies
Its investments in the equity shares (including instruments compulsorily convertible into
equity shares within a period not exceeding 10 years from the date of issue) in group
companies constitutes not less than 60% of its Total Assets

It does not trade in its investments in shares, debt or loans in group companies except
through block sale for the purpose of dilution or disinvestment

It does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the
RBI act, 1934 except investment in bank deposits, money market instruments, government
securities, loans to and investments in debt issuances of group companies or guarantees
issued on behalf of group companies

Its asset size is Rs.100 crore or above and

It accepts public funds

Infrastructure Debt Fund: Non-Banking Financial Company (IDF-NBFC): IDF-NBFC is a


company registered as NBFC to facilitate the flow of long term debt into infrastructure projects.
IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5
year maturity. Only Infrastructure Finance Companies (IFC) can sponsor IDF-NBFCs.
Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFC-MFI is
a non-deposit taking NBFC having not less than 85%of its assets in the nature of qualifying
assets which satisfy the following criteria:

Loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not
exceeding Rs.60,000 or urban and semi-urban household income not exceeding Rs.1,20,000
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Loan amount does not exceed Rs.35,000 in the first cycle and Rs.50,000 in subsequent cycles

Total indebtedness of the borrower does not exceed Rs.50,000

Tenure of the loan not to be less than 24 months for loan amount in excess of Rs.15,000 with
prepayment without penalty

Loan to be extended without collateral

Aggregate amount of loans, given for income generation, is not less than 75 per cent of the
total loans given by the MFIs

Loan is repayable on weekly, fortnightly or monthly installments at the choice of the


borrower

Non-Banking Financial Company Factors (NBFC-Factors): NBFC-Factor is a non-deposit


taking NBFC engaged in the principal business of factoring. The financial assets in the factoring
business should constitute at least 75 percent of its total assets and its income derived from
factoring business should not be less than 75 percent of its gross income.
RBI agenda for 2016-17
NBFCs play a critical role in catering to under-served niche sectors. An orderly
Development of NBFCs has been a priority for the Reserve Bank as shadow banking operations
have a bearing on the stability of the financial system. In 2015-16, the focus of Department of
Non Banking regulation (DNBR) was to take forward the process of harmonisation of
regulations across NBFCs and banks and move towards activity-based regulation. As in the past,
the process of regulatory convergence between NBFCs and banks will be carried forward in
2016-17. Furthermore, the year will also witness policy measures towards grouping NBFCs into
fewer categories. As part of public consultation process, the feedback from stakeholders and
public on the draft directions for NBFC and the consultation paper on Peer to peer lending has
been received. The feedback is being
Examined to finalize the directions and initiate the process of granting in-principle approval for
NBFC and also to finalize the contours of regulation of P2P platforms.

Introduction of account aggregator NBFCs


As step towards the aim of financial inclusion, the RBI released a draft regulatory framework on
account aggregator NBFCs. Such NBFCs will perform the function of consolidating all financial
information of a person across banks, insurance companies, mutual funds etc., in a common
format. It will enable the common man to easily access all his accounts across financial
institutions in a common format. It will be interesting to see how this segment of NBFCs kicksoff in the market.
Liberalizing foreign investment in the NBFC sector:
Harmonization of provisions of the regulations for foreign direct investment (FDI) in an NBFC
with the RBI-NBFC directions is another important area which is finally gaining some traction.
The finance minister in his Budget speech on 29 February 2016 announced the governments
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intention to permit FDI in all financial activities which are regulated by an Indian regulator under
the automatic route. For example, once the commodity broking license is approved by the
Securities and Exchange Board of India (SEBI) that company will not require any further
approval from the Foreign Investment Promotion Board (FIPB) for bringing in foreign
investment. Similarly, undertaking investment activity by an NBFC having foreign investment
requires approval from the FIPB. This is because, under the FDI norms, the only head under
which NBFC activities are covered under automatic route is leasing and finance. However, the
term finance has not been defined. Based on its general meaning, while lending activity
would get covered, investment activity does not specifically get covered. Once the abovementioned change is notified, it would be interesting to see if NBFCs are permitted to undertake
investment activities without the FIPBs approval.

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest


Act, 2002, (SARFAESI Act) coverage though banks and public financial institutions enjoy the
SARFAESI Acts benefit, the NBFCs were kept outside the purview of this framework. This put
undue hardship in recovery of bad loans by NBFCs. Both the Thorat Committee and the
Nachiket Mor Committee recognised this and recommended that NBFCs be given access to
benefits under the SARFAESI Act. In his Budget speech in 2015, the finance minister announced
that NBFCs would be considered as an eligible financial institution for SARFAESI benefits.
However, the corresponding amendment in the SARFAESI Act is still yet to be introduced. This
appears to be a mere omission and hopefully, the relevant amendment would be incorporated in
the SARFAESI Act soon. Coverage of NBFCs under the SARFAESI Act would go a long way
towards creating a level playing field for NBFCs with banks.

Simplification of the NBFC application process to make the process of registration of new
NBFCs smoother and hassle free, RBI Governor, Dr Raghuram Rajan, announced in the sixth bimonthly policy for 201516, the RBIs intention to simplify and rationalise the process of
registering new NBFCs. The new application forms will be simpler and the number of
documents required to be submitted will be reduced to a minimum
Developments:

Companies in infrastructure sector, NBFC-IFCs, NBFC-AFCs, holding companies and CICs


were made eligible to raise ECB under Track I of the framework with minimum average
maturity of 5 years, subject to 100 per cent hedging; exploration, mining and refinery
sectors would be deemed as infrastructure for the purpose of ECB; and refinancing of
ECBs raised under the old regime was allowed.
For determination of concentration of credit/ investment, investments of NBFC in the shares
of its subsidiaries and companies in the same group should be excluded to the extent they
have been reduced from owned funds for calculation of NOF.
NBFCs would require prior approval of the Reserve Bank in cases of acquisition/ transfer of
control of NBFCs.
Guidelines on early recognition of financial distress, prompt steps for resolution and fair
recovery for lenders: framework for revitalising distressed assets, review of the guidelines
on JLF and corrective action plans as applicable to banks were made, mutatis mutandis,
applicable to NBFCs.

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Guidelines on restructuring of advances as applicable to banks were made, mutatis


mutandis, applicable to NBFCs
The limit of loan issued by NBFC-MFIs with a tenure of not less than 24 months was raised
to `30,000 from `15,000
NBFCs should disclose that the safe deposit locker facility is not regulated by the Reserve
Bank. It would be a fee-based service and should not be counted as part of the financial
business carried out by NBFCs.
Threshold for fraud reporting by NBFCs to the Central Fraud Monitoring Cell was increased
to 10 million from `2.5 million.

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Mutual Funds
A mutual fund, as the name suggests, is a pool of funds of the investors. Investors pool their
money to form a corpus of funds, which is then invested in a portfolio of securities by the Asset
Management Company. The returns earned on the securities are returned back to the investors in
proportion to their investments, after charging some fees and commission.
Mutual funds provide the benefit of expert advice in investment and diversification, even to
small investors, who cannot practically conduct detailed analysis of the securities, nor can invest
in, say more than 10 of them at the same time.
Mutual funds may be open end or closed end funds, the definitions for which are given as
follows:
Open end funds: Open end funds are those mutual funds in which investors may invest and
withdraw at any time. These are the most common type of mutual funds. However, they are not
traded on exchange.
Closed end Funds: Close end funds are those mutual funds in which the investors money is
locked in for a particular period. Investors who want their money back cannot get it back directly
from the fund. They will have to sell their assets in the funds to other investors on the exchange.
Terms to be tracked for a Mutual Fund are:
Asset Under Management (AUM): The market value of assets that a mutual fund manages on
behalf of investors. AUM is looked at as a measure of success against the competition and
consists of growth/decline due to both capital appreciation/losses and new money
inflow/outflow.
Net Asset Value (NAV): A mutual fund's price per share value. In both cases, the per-share
dollar amount of the fund is calculated by dividing the total value of all the securities in its
portfolio, less any liabilities, by the number of fund shares outstanding.
Entry & Exit Load: Mutual fund companies collect an amount from investors when they join or
leave a scheme. This fee is generally referred to as a 'load'. Entry load can be said to be the
amount or fee charged from an investor while entering a scheme or joining the company as an
investor whereas the fee charged from an investor while redeeming or transferring a scheme is
termed as exit load. Post August 2009 in India only entry load can be charged and this load
balance is not included in the NAV calculation.
New Fund Offer (NFO): A security offering in which investors may purchase units of a closedend mutual fund. A new fund offer occurs when a mutual fund is launched, allowing the firm to
raise capital for purchasing securities.

Corpus: The total amount invested by a mutual fund or its scheme is called a corpus.

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Mutual Fund Industry in India
The first mutual fund in India was the Unit Trust of India (UTI) set up in 1963. Privatisation was
allowed in 1993. The regulatory body for mutual funds in India is SEBI.
Top three companies in India according to Asset under Management as on June 2016 are:
1. ICICI Prudential Mutual Funds(INR 193,296 crores)
2. HDFC Mutual Funds (INR 1,92,776 crores)
3. Reliance Mutual Funds (INR 1,67,009 Crores)

Other Financial Services


Financial services are the economic services provided by the finance industry, which
encompasses a broad range of organizations that manage money, including credit unions, banks,
credit card companies, insurance companies, finance companies, stock brokerages, investment
funds and some government sponsored enterprises.
Intermediary Advisory Services
These services involve stock brokers (private client services) and discount brokers. Stock brokers
assist investors in buying or selling shares. Primarily internet-based companies are often referred
to as discount brokerages, although many now have branch offices to assist clients. These
brokerages primarily target individual investors. Full service and private client firms primarily
assist and execute trades for clients with large amounts of capital to invest, such as large
companies, wealthy individuals, and investment management funds. E.g. - Sharekhan, Anand
Rathi, etc.
Private Equity
Private equity funds are typically closed-end funds, which usually take controlling equity stakes in
businesses that are either private, or taken private once acquired. Private equity funds often use leveraged
buyouts (LBOs) to acquire the firms in which they invest. The most successful private equity funds can
generate returns significantly higher than provided by the equity markets. Greater activity in this segment
supports Banking Institutions as they very often use debt in their deals; also they create a very sound
environment of investment which indirectly boosts requirement for BIs. E.g.- Warburg Pincus,
Blackstone, etc.

Conglomerates
A financial services conglomerate is a financial services firm that is active in more than one
sector of the financial services market e.g. life insurance, general insurance, health insurance,
asset management, retail banking, wholesale banking, investment banking, etc. A key rationale
for the existence of such businesses is the existence of diversification benefits that are present
when different types of businesses are aggregated i.e. bad things don't always happen at the same
time. As a consequence, economic capital for a conglomerate is usually substantially less than
economic capital is for the sum of its parts. E.g. Indiabulls, India Infoline, MotilalOswal etc
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PSB vs Private Banks


PSBs have been struggling for quite some time due to the problem of NPAs. Their loan growth
as well as their profitability is severely affected and they have underperformed private banks on
many fronts. The loan growth for PSB is consistently lower than private banks as can be seen
from the below graph, with the exception of few quarters.

Due to dismal loan book growth, PSBs have lost a significant market share and have lost almost
4 % in a span of 2 years. The erosion of assets due to bad debts has also contributed to the shift
of balance towards private banks

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NIM:
Historically PSB had maintained NIM near 3% and private banks had margins higher by ~ 1%.
The gap has widened significantly in 2016 due to lower NIM of PSB and the reason of which has
been the income loss and high slippages.

Cost to Income Ratio:


The cost to ratio for PSBs has spiked up to because revenues were impacted from large interest
reversals due higher slippages. For private banks the same improved due to better business
growth and stable margins

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Sector Outlook:
Deposits:
Bank deposits are forecast to increase by 10-11% in 2016-17, compared with 9% reported in 2015-16,
backed by an expected pick-up in economic growth and higher disposable income on account of low
inflation.

Decline in CASA deposits


With companies opting to put money in more attractive market instruments, the share of current
account deposits in banks' total deposits has begun to shrink. Moreover, current account
transactions have reduced. The current account-savings account (CASA) ratio is forecast to slip
marginally to 32.4% by the end of March 2016 from 33.4% as of March 2014.
This trend is mirrored even in savings account deposits. With advancements in technology,
customers have been increasingly transferring their savings account balances beyond a prespecified level to term deposits to earn higher interest income (interest rates on fixed deposits are
3-5% higher than those earned on savings account deposits). Term deposits recorded strong
growth in 2014-15, mainly on account of the rising opportunity cost of holding cash or demand
deposits, as the interest rates on term deposits were higher.

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Credit
Growth in gross bank credit in FY16 was marginally better than that in FY15, though
there was a varied picture across segments. Hence, while 9% growth was higher than 8.6% in
FY15, there were limited signs of a pickup in manufacturing sector in particular.
Table below shows that most of the outstanding credit was in the category of non-food credit.
The interesting facet of this profile is the higher share of personal loans in total credit
outstanding. The share has increased from 18% in FY14 to 19% in FY15 and 21% in
FY16. Banks have been more active in this segment, where demand has been relatively robust
and the quality of assets better placed.

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The performance in FY17 will depend on how the manufacturing sector fares as this is required
for
revival in growth in bank credit. With a share of above 40%, it is the driving force.
While overall growth in bank credit has shown an improvement in FY16, it has been mainly due to the
buoyancy witnessed in the personal and services sector, with the former being dominant while credit
to
manufacturing continued to be down beat

Retail segment to be the key driver for credit growth in 2016-17


Retail accounts for a fifth of overall systemic credit and hence higher growth in retail will also be
the key driver for credit growth. With slow growth in the corporate-loan portfolio, banks have
shifted focus to retail, in which growth and risk-reward opportunities are more favorable in the
current leg of the cycle. Retail lending has gone through a change and banks are well-placed to
build a strong portfolio over the next few years. High impairment in the corporate-loan portfolio
and relatively lower risk in retail is leading to high growth in retail portfolio

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Banks losing share to CP and bonds

Yield differences remained high in 2015-16; the gap will come down in 2016-17 as the
better
transmission of rate cut will pass on to the borrowers
FII investments in corporate bonds are also increasing

Weak capitalization of PSBs to restrict credit growth

PSU banks credit growth has fallen sharply by 4 % in year and now stands at
63%
Private sector banks to gain market share over PSU banks

Over the past several years bond markets have picked up especially for well rated corporates.
They have resorted more to bond markets than bank loans for their short term needs. Also
borrowing through bond markets was cheaper than from banks for well-rated corporates as banks
by regulation could not lend below base rates, which were essentially linked to cost of funds but
the introduction of MCLR effective from April 01, 2016 will overcome this issue

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National Housing Bank:


National Housing Bank (NHB), a wholly owned subsidiary of Reserve Bank of India (RBI), was
set up on 9 July 1988 under the National Housing Bank Act, 1987. NHB is an apex financial
institution for housing. NHB has been established with an objective to operate as a principal
agency to promote housing finance institutions both at local and regional levels and to provide
financial and other support incidental to such institutions and for matters connected therewith.
NHB registers, regulates and supervises Housing Finance Company (HFCs), keeps surveillance
through On-site & Off-site Mechanisms and co-ordinates with other Regulators.

Housing Finance Company (HFCs)


A Housing Finance Company is a company registered under the Companies Act, 1956 (1 of 1956) which
primarily transacts or has as one of its principal objects, the transacting of the business of providing
finance for housing, whether directly or indirectly.

A company registered under the Companies Act, 1956 and desirous of commencing business of a
housing finance institution, should comply with the following(i) either it should primarily transacts or has as one of its principal objects of transacting the
business of providing finance for housing, whether directly or indirectly; and
(ii) it should have a minimum net owned fund of Rs. 10 crore.
NHB, after its satisfaction on the fulfillment of following conditions provided under sub-section
(4) of Section 29A of the National Housing Bank Act, 1987 by a company, may grant a
Certificate of Registration.
Net Owned Fund (NOF)
The aggregate of the paid-up equity capital and free reserves as disclosed in the latest balancesheet of the housing finance institution after deducting therefrom (i)

accumulated balance of loss;

(ii)

deferred revenue expenditure, and

(iii)

other intangible assets; and

b)

further reduced by the amounts representing

(i)

investments of such institution in shares of-

its subsidiaries;
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companies in the same group;

all other housing finance institutions which are companies; and

(ii) the book value of debentures, bonds, outstanding loans and advances (including hirepurchase and lease finance) made to, and deposits with,

subsidiaries of such company; and

Companies in the same group, to the extent such amount exceeds ten per cent

Difference between bank and HFC:


HFCs lend and make investments and hence their activities are akin to that of banks. However,
there are a few differences as given below:
(i)

HFCs cannot accept demand deposits;

(ii) HFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on itself;
(iii) deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of HFCs, unlike in case of banks.
Can all HFCs accept public deposits ?
For acceptance of public deposits HFCs can be divided into two categories, i.e. HFCs carrying
on the business of housing finance before June 12, 2000 and HFCs commencing housing finance
business after that date.
(a) Companies carrying on business of housing finance before June 12, 2000 can accept deposits
provided they have NOF of over rupees twenty five lacs and have applied for certificate of
registration with NHB before December 12, 2000 and either have been granted the certificate of
registration valid for acceptance of deposits by NHB or their application is still pending for issue
of certificate of registration with NHB.
(b) Companies commencing the business of housing finance after June 12, 2000 can accept
public deposits only after:
(i) obtaining certificate of registration from NHB valid for acceptance of deposits; and
(ii) having minimum net owned funds (NOF) of [rupees two crores or more]*.
*this amount was rupees twenty five lacs or more for HFCs which commenced business
before
February 16, 2002.
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Max Deposit Limit :
-

five times of its net owned fund for HFCs with A and above rating
two times of its net owned fund or rupees ten crores whichever is lower provided such HFC
complies with all prudential norms and also has capital adequacy ratio of not less than fifteen
percent as per the last audited balance sheet.

HFC Business
The major sources of funds for HFCs are funds from banks commercial paper, bonds and NHB.
Off late bonds have become one of the cheaper sources and HFCs are trying to reduce their
borrowing from banks
Despite the stiff pricing competition from SCBs, HFCs market share in retail housing loans has
seen a steady
Improvement from FY08. A comparison of housing loan growth rates for SCBs (housing loans
data from RBI)and HFCs (housing loan data from NHB) shows HFCs improved their share in
housing loans by ~10% FY08-FY14

Interest Rate Calculation


HFCs calculate interest rate using Prime Lending Rate (PLR) & Discount. The Prime Lending
Rate and Discount are the factors used by HFCs for deciding their interest rate. The PLR is
calculated by HFCs based on the cost they incur for raising their funds along with a certain profit
margin. The method for calculating PLR is not known. Lets say an HFCs PLR is 16%. What it
will do now, is discount this rate by a certain amount, say 5%. This Discount is decided by each
individual HFC.
Interest Rate = PLR Discount = 16-5 = 11%.

Benefits of HFCs over Banks

Leniency in documentation, eligibility and credit score assessment


Quicker loan disbursal

Benefits of Banks over HFCs


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Lower interest rate


Long term savings
When RBI reduces Base Rate, the benefit is promptly passed to the customer

Micro-banking
Micro-banking, a formalized and regulated lending market is an outcome of the inability of the
Indian banking space to penetrate deeper into the un-served population. Micro-banking, also
termed as shadow banking, is broadly classified into Self Help Group (SHG) bank-based lending
approach and microfinance institutions (MFI) and has been in existence for years (SHG model
was first introduced in 1990s). While individual lending is also a part of microfinance credit in
India, its market size has remained limited. Further, though at a nascent stage of implementation,
and also drawing parallels from individual-based lending approach globally, the Indian MFI
industry and especially some larger players are venturing into this segment.

The door-to-door based lending model is the key to success of the joint liability group (JLG)based MFI model in India; further, with strong credit policies in place and stringent regulations
including cap on lending norms have led to discipline among players. On the flipside, unsecured
nature of the product, high operating costs, need for feet on street sales and requisite collection
mechanism could be the reasons for the banking industry to have remained shy of the
opportunity.
The MFI industry has been through a roller-coaster ride in its initial and mere 10 years of
existence in India. Stringent regulations on lending norms, capital requirement and exposure
limits for the lender and borrower emerged post the AP crisis. The industry since then has
witnessed 48% AuM CAGR (ie, during FY12-16) led by improved reach, increase in customer
profile and surge in ticket size.
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Differentiated banking model small finance bank: The need for a differentiated banking
structure received greater emphasis following the discussion papers by RBI on Banking
Structure in India The
Way Forward in August 2013, which called for thrust on financial inclusion. Also, the need to
ensure healthy competition led to the need for a separate banking structure.
The RBI discussion paper states the following:
Small banks vs large banks: There is an ongoing debate on whether we need small number of
large banks or large number of small banks to promote financial inclusion. Small local banks
with geographical limitations play an important role in the supply of credit to small enterprises
and agriculture. While small banks have the potential for financial inclusion, their performance
in India (local area banks and urban co-operative bank) has not been satisfactory. If small banks
are to be preferred, the issues related to their size, numbers, capital requirements, exposure
norms, regulatory prescriptions and corporate governance need to be suitably addressed. Small
finance banks (SFB) have been carved out with the prime objective of ensuring financial
inclusion through credit supply to small business units, small & marginal farmers, micro & small
industries and other entities in the unorganized sector through high-technology and low-cost
operations. Accordingly, RBI has given in-principle approval to 10 entities, of which eight are
MFIs. The inclusion of MFIs in the SFB license shows the significance of the MFI industry in
enabling financial inclusion.

MFI industry: huge growth potential

Emerged as a fast growing sector with 48% CAGR in AuM over FY12-16, led by 22% /
21% CAGR rise in volumes (no. of borrowers) and value (loan O/s per borrower).
Self-regulatory associations (SRO), credit information bureaus (CIB), cap on lending
spreads, provisioning requirement and capital requirement have resulted in discipline
among players.
Penetration in India still lower than MFI operations globally. Market opportunity pegged
at Rs2.7-3tn, implying strong growth potential in the longer run.

The fall and rise of the sector

With mere 10 years of existence in India, the microfinance industry has already been through a
rollercoaster ride: a) the FY06-10 period was characterized by robust growth and profitability; b)
in the period thereafter, i.e. FY11-13, wherein NPAs rose, portfolio ran down and many MFIs
went bankrupt following AP crisis; and finally c) the period post FY13 was characterized by
high growth rates due to increased reach. The sector has emerged as the fastest growing one,
with 48% CAGR in AuM, led by over 2x rise in volume (no. of borrowers at 32.5mn in FY16 vs
14.8mn in FY12) and 21% rise in value. Ticket size per borrower stood at Rs16, 379 vs.
~Rs.7,550 in FY12. The penetration has extended to cover 32.5mn (vs 13.4mn in FY13) through
branch reach of 9,669 and across 30 states/union territories.
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Interest Rate Calculation for MFI


The interest rates charged by an NBFC-MFI to its borrowers will be the lower of the following:
i. Cost of funds, plus margin
Cost of funds means interest cost and margin is a markup of a maximum of 10 per cent for large
NBFCs-MFI and 12 per cent for others. Large NBFCs-MFI are those with loans portfolios
exceeding Rs.100 crore.
ii. The average base rate of the five largest commercial banks by assets multiplied by 2.75
The average of the base rates of the five largest commercial banks shall be advised by the
Reserve Bank on the last working day of the previous quarter, which shall determine interest
rates for the ensuing quarter.
RBI has removed the cap interest rate of 26% but the maximum variance permitted for individual
loans between minimum and maximum interest rate cannot exceed 4 per cent.
Asset Quality:
Though MFI industry is perceived to be of high risk the asset quality has remained robust due to group
lending dynamics. The percentage of loans unpaid for 30,90 and 180 days is as shown in the below figure.

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The average ticket size in MFI has been increasing over the years. The average ticket size (loan size) in
the industry stood at Rs 16,394. Increasing ticket size is a good signal for MFI because the loan book
increases due to it but increasing ticket size is also perceived to be a signal of increasing risk though there
is no ideal ticket size which could be used as benchmark.
As per RBI regulation there is threshold limit of Rs 30,000 for loans of tenor less than 2 years

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Company Coverage: Bharat Financial Inclusion Limited


The Bharat Financial Inclusion Limited (BFIL) was earlier known as SKS Microfinance and was founded
by Vikram Akula in 1997 who remained CEO till 2011.After the conversion of Bandhan into a bank

BFIL is now the second largest MFI in terms of market share.Post the conversion of Bandhan
financial services as a bank the MFI industry charts in terms of Gross Loan Portfolio looks as
follows

As of March 31, 2016 BFIL had 4.64m borrowers and 5.57 members. BFIL was formed as an
independent company and does not have a holding company or subsidiaries. MFI loans to
women borrowers constitute 98.7% of the total AUM.
BFIL has one of the lowest average amount of loan disbursement per account, the comparison of
the same with industry average is as follows

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Borrowing Cost:
BFIL source of funds just like other MFI are banks and debt funds. The lender among banks for
BFIL have been SBI, Dena Bank, Yes for FY16.

The cost of borrowing for BFIL has been as shown in the figure. It is to be noted that the cost of
borrowing for for BFIL and for MFI industry in general is very high ( above 10%) unlike banks
which have borrowing cost close to ( 5-6%). This is because banks major source of funds are
retail deposits and a significant part of it is current and savings accounts which are needs to be
paid interest in the range of (4-6%, RBL is an exception with 7% with certain terms and
conditions to avail it). For MFI banks and debt are source of funds which do not come cheap.

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The loan are charged based on either fixed rate or floating rate. The loan mix of fixed rate vs
floating rate is as shown in the figure.

For BFIL the cost to income ratio has been decreasing over the years which is due to operational
efficiency. It has one of the lowest cost/Income ratio among MFIs. MFIs have high cost to
income ratio which is above 50% for most and the reason is the high cost involved in fetching
each customer and the ticket size of each customer is much lower in comparison to banks.

Banking , Financial Services and Insurance

Asset quality for BFIL been pretty well with net NPA close to 0 (0.03%).
BFIL has leverage at 4.9x well below the RBI cap of 13x and has healthy CAR of 23% against
requirements of 15%.
BFIL currently charges interest rate of 19.75 % for all fixed rate loans and is the only MFI which
charges interest rate lower than 20% and the first one to do so. The higher interest rate is another
characteristics of MFI domain due to high risk associated with the loans as compared to retail or
corporate loans given by banks. BFIL has an interest spread of 11.4% for FY16.
Since the spread is higher in MFI, NIM (Net Interest Margin) is also high for MFIs and for BFIL
it stood at 11.9% for FY16.

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