INDIAN BANKING - IN RETROSPECT AND PROSPECT

The banking industry in India is poised to undergo a fundamental change in the

next 18 to 24 months and India will emerge as one of the strong markets for private
and international banks in the next few years. There is need for retail distribution of
technology in the banking sector, because while public sector banks have 84% of
banking deposits and 90% of accounts, nationalized banks have just 38% of the
country’s ATM network. The Reserve Bank of India (RBI) has to bring about certain
fundamental changes in the banking industry in India. Just 9% of urban households
avail auto loans, only 11% have access to mortgages and just 7% have credit cards
although they can afford them “ Obviously a lot more needs to be done in the banking
industry in India”. - ( Navin Tahilyani 2004.)

The Moody’s weighted average bank financial strength index ranks India above
quite a few developing countries. The financial strength index is constructed
according to a numerical scale assigned to the different weighted average bank ratings
of countries. The table given below shows that India has been ranked above Japan,
Brazil, Korea, Russia and Philippines using this measure. That is interesting,
especially since the Indian banking sector is widely believed to be plagued by huge
non-performing assets. In fact, analysts pointed out that apart from the reported
NPAs, which on an average amount to around 10% of total assets of banks, there are
also a lot of hidden NPAs making the

 Dr. Thaduri Balaraju is faculty Member in Commerce and Business

Management, University Arts & Science College, Kakatiya University,
Warangal – 506 001 ( India )

14 1
 INDEX SHOWING FINANCIAL STRENGTH OF BANKS

IN SELECTED COUNTRIES
Country Financial Strength ROA (%) NPA/Total Loans
Index (%) (%)
Chile 52.0 1.9
1.0
Mexico 39.6 1.0 4.8
Malaysia 31.7 -- 10.3
India 27.5 0.8 10.4
Brazil 25.0 2.0 6.1
Columbia 24.2 1.2 6.1
Philippines 20.4 1.3 16.4
Korea 16.7 0.8 3.8
Thailand 15.8 0.7 10.4
Japan 12.9 -0.4 8.9
Russia 10.8 3.2 --
Indonesia 05.4 1.8 16.6
Pakistan 05.4 1.8 16.6

SOURCE: The IMF Global Financial Stability report May, 2003.

Indian financial sectors rather fragile. Moody’s rankings obviously suggest

that there are quite a few developing countries where things are worse. The IMF
Global Financial Stability Report supports this view to some extent. The Indian
banking sector’s return on assets of 0.8% was better than the ROAs of Thailand and
Japan. Similarly, in terms of NPAs as a percentage of total assets, the Indian banking
sector is better off compared to Indonesia, Venezuela and Philippines. Besides, strong
liquidity, falling interest rates and an increasing demand for retail loans, things have
hardly been better for the Indian banking industry.

OBJECTIVES OF THE STUDY:

14 2
The objectives of this paper are to focus upon the new dimensions in Indian Banking
Industry with particular reference to:
* Factors affecting competitiveness and efficiency of banks and
* Some other new tendencies in the banking system.

FACTORS AFFECTING COMPETITIVENESS AND EFFICIENCY:

a) Growth in Information Technology:

Financial institutions, instruments and markets constituting the financial sector

play a major role in the mobilization and allocation or resources. Banks form
the most important segment of the financial sector. Consequent to various
developments covering, interalia, the tremendous growth in information
technology which dismantled the geographical boundaries and the prolific
growth of the non-bank financial companies that made a dent on the bank’s,
assured clientele, the competitive environment in the banking industry has
increased. A few banks which have impressive branch networks have not been
able to meet their customer’s expectations due to inefficiencies arising out of
inadequate investment in technology and consequently faced an erosion of their
market shares. The beneficiaries are those banks, which have invested in
technology. Another distinct advantage of use of technology is the ability to
effectively use quantitative techniques and models which can enhance the
quality of their risk management systems.The challenge in this regard will be
for banks to ensure that they derive maximum advantage out of their
investments in technology. - ( V. Leeladhar, 2005)

b) Policy Changes:

14 3
 Changes in the banking policy further facilitated the creation of a competitive
environment. Deregulation of banking through abolition of administered rates
for deposits and loans gave the banks the freedom in fixing prices for their
products. To compete effectively with non-bank intermediaries, the banks
were permitted to undertake newer activities like investment banking, securities
trading, insurance business, etc., though on a selective basis. Easing entry
barriers increased the number of players in the market. In this set up, margins
on traditional banking business declined prompting the banks to look from
more fee-based services, and simultaneously, the banks were forced to pay
maximum attention to operational efficiency so that their transaction costs
remained at the minimum. Increased competitiveness’ led to inevitable
changes in the market. The weak players were either crowded out or they were
amalgamated with the strong ones.
As a policy measure, the interest rates in the banking system have been
largely deregulated except for certain specific classes: these are: savings
deposit accounts, non-resident Indian (NRI) deposits, small loans upto Rs.2
Lakhs and export credit. Another Policy measure of diversification of
ownership has led to greater market accountability and improved efficiency.
Since the initiation of reforms, infusion of funds by the government into the
public sector banks for the recapitalization accounted on a cumulative basis, to
less than one percent of India’s G.D.P. But this involvement resulted in the
manifold increase in the current market value of the share capital of the
Government in public Sector banks and it turned out to be a profitable
investment for the government. - ( Y.V. Reddy-2005.)
Another recent policy decision has been to raise the short term interest
rate by 25 base points or 0.25 percent point in January,2006 to contain inflation
within the projected range of 5 to 5.5 percent. It raised the forecast for
economic growth to 7.5 to 8 percent in the current financial year.
-(Reported in The Hindu ,January 26, 2006.)

c) Efficiency:

14 4
 Efficiency is economic and is measured by comparing actual and optimum
cost, revenue or profit – whichever the operating unit is expected to pursue.
Estimation of the frontier function is at the center of studies on measurement
of efficiency. This approach has been extended to the banking industry also.
The major issue in such an exercise has been to identify suitable indicators
for bank’s outputs and inputs. As an alternative to measuring efficiency using
frontier function approach, banks’ efficiency can also be measured in terms
of certain ratios of costs to assets or operating revenues.

Some recent studies have examined the efficiency effects of bank

mergers using the ratios of ( i ) non – interest operating expenses / total
expenses to assets, ( ii ) total expenses to total revenue ( iii ) non-interest
expenses to adjusted operating revenue ( net interest income + non-interest
income ), and ( iv ) staff expenses to assets. A decrease in the above ratios
post-merger, was indicative of improvement in efficiencies

While different methods have been adopted to estimate the efficiency

components, a number of studies have also attempted to explain the
efficiency differences among the banks through various bank-specific,
market-specific and regulatory characteristics. These studies have important
implications for public policy and bank management. A review of these
studies indicated that no consistent relationship emerged between variables
like asset size, organizational form, market concentration and efficiency.
However, the well capitalized banks were found to be more efficient and
these efficient banks had lower levels of non-performing loans. Indian
studies in bank efficiency and productivity have been evolving in the 1990’s.
Quite a few papers have estimated Total Factor Productivity (TFP) growth in
Indian banking, which is growth of output relative to input usage. A few
studies that have estimated the TFP growth revealed contrasting results like
technical change is the main contributor to TFP growth, deregulation has led
to improvement in TFP growth and there is no significant impact of

14 5
 deregulation on TFP growth. Another study was based on evaluating
performance on the basis of financial ratios of efficiency and profitability and
concluded that Private Banks are not unambiguously superior to Public
Banks. A sequential decomposition model for profitability analysis of Public
Sector banks found that there is a convergence in bank wise profitability in
the post-reform period. In recent times international research in bank
performance shifted towards the concept of frontier efficiency measurement,
which measures inefficiency as the deviation of a firm from the efficient or
best practices frontier. There are parametric and non-parametric approaches
for the estimation of such a frontier. Using a non-parametric approach, called
as Data Envelopment Analysis ( DEA), it was found that Public sector banks
improved their allocative efficiency significantly in the post reform period,
but there was a fall in scale efficiency. A study estimating TFP growth for
all banks using DEA concluded that there is no significant difference
between productivity of different bank groups. The parametric approach
used in frontier efficiency approach is called as Stochastic Frontier Analysis
(SFA), using SFA for estimating cost and profit efficiencies in Indian
banking over a longtime horizon of 18 years it was found that public banks
have shown higher cost efficiency than private banks, whereas it has been
otherway round in the case of profit efficiency. New Private and foreign
banks exhibit the least efficiency in terms of both measures. Moreover, cost
efficiency improved during the sample period while profit efficiency
underwent a decline. - ( Rudrasen Sarma, 2005)
One of the major factors affecting efficiency is the organizational
structure of the banks. With a view to heaping the full benefits of
liberalization, the organizational structures of banks need to undergo a
change. Another issue that assumes importance in improving the efficiency
of the banks is human resource development. In a major push to banking
reforms in our country, the Government of India has announced last year a
slew of HR autonomy incentives for better performing banks. Differential
pay structures, lateral entry, contract employment and performance linked

14 6
 pay as a sub component of the compensation structure may turnout to be a
potent talent management instrument in Public Sector banks too.
- [V.Leeladhar (a), 2005 ]

SOME OTHER NEW TENDENCIES:

some other new tendencies in the banking industry in the recent past are as given here
under:

1) Institutional and Legal reforms:

Banking services has changed rapidly since 1990s, The decade of 90s has
witnessed a change in the way banking is done in India. Technology has made
tremendous impact in banking. ‘Anywhere banking’ and ‘Anytime banking’ have
become a reality. The financial sector now operates in a more competitive
environment than before and intermediates relatively large volume of international
financial flows. In the wake of greater financial deregulation and global financial
integration the biggest challenge before the regulators is of avoiding instability in the
financial system. - [V.Leeladhar (b), 2005 ]

In order to face this challenge, a Board for Financial Supervision (BFS) was
constituted in 1994. The BFS provides direction on a continuing basis on regulatory
policies including governance issue and supervisory practice. It also ensures an
integrated approach to supervision of commercial banks, development finance
institutions, non-banking finance companies, urban co-operative banks and primary
dealers. A Board for Regulation and Supervision of Payment and settlement system

(BPSS) has also been recently constituted to prescribe policies relating to the
regulation and supervision of all types of payment and settlement systems, set
standards for existing and future systems, authorize the payment and settlement
systems and determine criteria for membership to these systems. The credit

14 7
information companies ( Regulation ) Bill, 2004 has been passed, Major amendments
relate to requirement of prior approval of the RBI for the requisition of five percent or
more of shares of a banking company with a view to ensuring ‘fit and proper’ status of
the significant shareholders, aligning the voting rights with the economic holding and
empowering the RBI to suspend the Board of a banking company.
- (Dr. Y.V.Reddy, 2005 )

2) Capital Adequacy Norms:

Regulation of banks is justified on the ground that depositors are unable to

monitor the financial soundness of banks and that there is a risk of systematic
crisis. The regulatory framework and supervisory practices have almost converged
with the best practices elsewhere in the world. - ( Dr. Y.V. Reddy, 2005 )

One of these practices has been to keep the minimum capital to risk assets ratio
(CRAR) at 9 percent, that is one percentage point above the international norm;
and second the banks are required to maintain a separate Investment Fluctuation
Reserve (IFR) out of profits towards interest rate risk, at five percent of this
investment portfolio under the categories, ‘ held for trading’ and ‘available for
sale’. Also, the conservative accounting norms did not allow banks to recognize
the unrealized gains. Such unrealized gains coupled with the creation of IFR
helped in cushioning the valuation losses required to booked when interest rates in
the longer tenors have moved up in the last one year. The buoyant capital market
has been attracting large foreign institutional inflows during the recent past. In this
context operationalization of Market Stabilization Scheme (MSS) has given an
additional instrument for liquidity and monetary management .
- [ V. Leeladhar (b),2005 ]

A Study highlighted how competitive forces, may, in principle motivate banks

to select high capital adequacy ratios as a means of lowering their borrowing costs.
Further, better-capitalized banks experienced lower borrowing costs. Also, bank

14 8
 competition could not have substituted for capital adequacy regulation because of
substantial systemic effects. These reasons might have prompted bank for the
observed non-compliance which stipulates capital adequacy requirement,
competition is motivating banks to select higher capital adequacy ratios than
otherwise. The adoption of Basel II norms in future with its focus on risk sensitive
capital requirements and market discipline through greater transparency is the next
challenge that the banking system would be facing.
- ( Saibal Ghosh & Abhriman Das, 2005)
3) Move towards universal Banking:
The new era is going to be one of consolidation around identified core
competencies. Mergers and acquisitions in the banking sector are going to be the
order of the day. Successful merger of HDFC Bank and Times Bank earlier and
Stanchart and ANZ Grindlays three years ago has demonstrated that tendency towards
consolidation is almost an accepted fact. Such signs are visible in the case of a
number of old private banks, many of which are not able to cushion their NPAs and
expand their business and induct technology due to linked capital base. Coming time
may usher in large banking institutions if the development financial institutions opt for
conversion into commercial banking in line with the recommendations of Narasimha
Committee (II).
In India, one of the largest financial institutions, Industrial Credit and Investment
Corporation of India (ICICI) took the lead towards universal banking with its reverse
merger with ICICI Bank. Another mega financial institution, Industrial Development
Bank of India (IDBI), has also adopted the strategy, and has already transformed itself
into a universal banking. This tendency may lead logically to promoting the concept
of financial supermarket chain, making available all types of credit and non-fund
facilities under one roof or specialized subsidiaries under one umbrella organization.
[V.Leeladhar (b),2005]
CONCLUSION:

In future Banks are more prone to risks and risk management will assume
greater importance. Increasing competition will be the new dimension of Indian

14 9
banking. Hence banks have to seek new avenues to augment their revenues and
innovative approaches are needed. Cost efficiency, consolidation and risk
management may be critical factors, but good governance can also play a vital role in
modernizing the banking system.

REFERENCES

Vasant Desai : The Indian Financial system and Development –

Himalaya publications,Mumbai-2005.

14 10
M.Y.Khan : Financial Services – Tata McGraw Hill,
New Delhi-2004.

K.P.M.Sundaram : Latest developments in Banking Finance Commerce and

Industry - S.Chand & Company Ltd, New Delhi-2002.

Navin Tahilyani : As quoted in the Journal of Banking Studies,

January, 2004 .

V.Leeladhar :Indian Banking – The Challenges Ahead,

RBI Bulletin,December,2005.

Dr.Y.V.Reddy :Banking Sector Reforms in India;An

Overview,RBI Bulletin, June,2005.

The Hindu : January 26, 2006.

Rudrasen Sarma : Cost and Profit Efficiency of Indian Banks during

1986-2003, Economic & Political Weekly,
March 19,2005.

V.Leeladhar (a) :Managing Talent in Banks: A fewthoughts, RBI Bulletin,

April,2005.

V.Leeladhar (b) :Contemporary and Future Loans in Indian Banking,

RBI Bulletin, March,2005.
Saibal Ghosh &
Abhriman Das :Market Discipline,Capital Adequacy and Bank
Behaviour, Economic & Political Weekly,
March 19,2005.
Journal of
Banking Studies : Volume XXIV,No.1 April,2004.

Journal of
Banking Studies : Volume XXV No.6 June, 2004.

Journal of
Banking Studies : Volume XXVI No.7 January, 2005.
Journal of
Banking Studies : Volume XXVII No.6 March , 2005.

***

14 11
14 12