Issues And Challenges in Banking

Introduction
The Banking sector in India has always been one of the most preferred avenues of employment. In the current decade, this has emerged as a resurgent sector in the Indian economy. As per the McKinsey report India Banking 2010, the banking sector index has grown at a compounded annual rate of over 51 per cent since the year 2001, as compared to a 27 per cent growth in the market index during the same period. It is projected that the sector has the potential to account for over 7.7 per cent of GDP with over Rs.7,500 billion in market cap, and to provide over 1.5 million jobs. Today, banks have diversified their activities and are getting into new products and services that include opportunities in credit cards, consumer finance, wealth management, life and general insurance, investment banking, mutual funds, pension fund regulation, stock broking services, custodian services, private equity, etc. Further, most of the leading Indian banks are going global, setting up offices in foreign countries, by themselves or through their subsidiaries.

The Present Scenario

The current economic situation provides a lot of opportunities as well as challenges to the existing banks. It is up to the banks to leverage the opportunities to meet the challenges to the best of their abilities. The past year witnessed a lot of turmoil in the Indian banking industry owing to the global financial crisis. The Reserve Bank of India (RBI), Ministry of Finance and other regulatory authorities have made several notable efforts to improve regulation in the sector. Many big banks operating in the market have made use of the changed regulations (viz., change in CRR and interest rate) to provide better options to potential and new customers. Adoption of new practices to cater to the demanding economy situation has enabled the banks to meet the changing customer requirements. Compared to other regional banks, over the last few years, Indian banks have performed favorably on growth, asset quality and profitability. The banking index has grown at a compounded annual rate of over 51% from April 2001 compared to the market index for the same period, which registered a growth rate of 27%.

The crisis that hit the financial services industry initially in the US and almost immediately in the entire world has moved our focus towards critical systemic issuesnot only in the US banking business but also in India. Globally, these systemic issues are being tackled at the legislative and regulatory levels; in India, the solution to the systemic issues will require significant inputs and regulatory, industry and infrastructural interventions. To ensure survival, banks tried to quickly assess their liquidity reserves and capital position to check if they had any exposure to the failing global entities. Additionally, this check also meant a clear pulling down of new/additional credit outflow, unless and until their positions were clear. Over a short span of time, the situation resulted in banks totally stopping the outflow of new credit. According to Indian Banks Association Data, retail credit growth dropped drastically from 30% in 2007 to 10% in 2008, owing to increased pressure on existing loan portfolios and the fear of anticipated mass job losses which would result in high NPAs. Analysts and credit rating agencies in their reports showed marginal to moderate increases in NPLs in assets such as two-wheelers, commercial vehicles and unsecured loans. Growth in mortgages, which forms 50% of banks' retail portfolio, was also hit due to upward movement in interest rates, restriction on collection practices and soaring real estate prices.

Issues and Challenges in Banking

Global challenges in banking
An overview of the global challenges would include the following: Basel II implementation; enhancing corporate governance; alignment of regulatory and accounting requirements; outsourcing risks; and application of advanced technology. I propose to cover these aspects now.

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

Comprehensive risk management: Under Basel I banks were

focused on credit and market risks. Basel II has brought into focus a larger number of risks requiring banks to focus on a larger canvas. Besides the increase in the number of risks, banks are now beginning to focus on their inter-linkages with a view to achieve a more comprehensive risk management framework. Basel II implementation, therefore, is being increasingly seen as a medium through which banks constantly endeavour to upgrade the risk management systems to address the changing environment.

Capital efficiency: Basel II prescriptions have ushered in a transition

from the traditional regulatory measure of capital adequacy to an evaluation of whether a bank has found the most efficient use of its capital to support its business i.e., a transition from capital adequacy to capital efficiency. In this transition, how effectively capital is used will determine return on equity and a consequent enhancement of shareholder value.

Enhancing corporate governance: The issues related to corporate

governance have continued to attract considerable national and international attention in light of a number of high-profile breakdowns in corporate governance. In view of the importance of the banking system for financial stability, sound corporate governance is not only relevant at the level of the individual bank, but is also a critical ingredient at the system level. A good governance culture is crucial for financial stability but since it is an intangible, rules may not be able to capture its essence effectively. Therefore, banks may have to cultivate a good governance culture building in appropriate checks and balances in their operations.

Compliance with international accounting standards

One of the prime international standards considered relevant for ensuring a safe and sound banking system is the Core Principles for Effective Banking Supervision issued by the Basel Committee on Banking Supervision (BCBS). Accounting standards are now a part of the set of twelve standards that have been identified by the Financial Stability Forum as conducive to a robust financial infrastructure. Derivative activity in banks in India has been increasing at a brisk pace. While the risk management framework for derivative trading, which is a relatively new area for Indian banks (particularly more in respect of structured products), is an essential pre-requisite, the absence of clear accounting guidelines in this area is matter of significant concern. It is widely accepted that as the volume of transactions increases, which is happening in the Indian banking system, the need to upgrade the accounting framework needs no emphasis.

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

Application of advanced technology

Technology is a key driver in the banking industry, which creates new business models and processes, and also revolutionises distribution channels. Banks which have made inadequate investment in technology have consequently faced an erosion of their market shares. The beneficiaries are those banks which have invested in technology. Adoption of technology also enhances the quality of risk management systems in banks. Recognising the benefits of modernising their technology infrastructure banks are taking the right initiatives.

Capacity building
As dictated by the changing environment, banks need to focus on appropriate capacity building measures to equip their staff to handle advanced risk management systems and supervisors also need to equally equip themselves with appropriate skills to have effective supervision of banks adopting those systems. In the likelihood of a high level of attrition in the system, banks need to focus on motivating their skilled staff and retaining them.

Conclusion

Thus, banking in India involves the cooperation and participation of many stakeholders for the desired changes to be made in the existing system. Last year, during the economic slowdown, when the banking system globally went for a toss, the Indian banking industry emerged as a strong performer owing to the coordinated efforts of policy makers and the banks in bringing these policies to action for the best of the economy. The Indian banking industry gathered the strength to sustain during such times through its huge deposit base, which is consistently on a growth path, central bank's proactive measures to steadily improve banks' balance sheet strength, and a demand in the economy for physical asset creation. These factors enabled the Indian banking sector to become stronger on the capitalization front and also ensure lower level NPAs and better spreads in the past one-and-a-half decade. The strength provided through timely measures has helped the industry and the economy in many ways. Last year, the economy witnessed perhaps the biggest and positive impact of higher credit growth in infrastructure- related companiespower, telecom and others. However, it was partially compensated by the reduction in other funding sources such as private equity and foreign institutional investors. The alarm will start ringing if the regulator decides to continue with the stimulus package for long. With dried-up liquidity and no borrowers (given the low credit growth), the banking system will continue to invest excessively in government securities, leading to fiscal deficit eventually. However, an increase in domestic liquidity has had a cascading effect on the asset price inflation. According to a report by Tata Securities, the YTD growth in deposits is 9%, while the credit growth is only 5.4%, resulting in the banks' looking for other investment opportunities. The high liquidity with banks forced them to invest in the liquid funds of mutual funds, which in turn invested in commercial papers of corporates at a lower coupon corporates would have otherwise borrowed at a higher cost from the banks for their working capital requirements.

The downturn which the economy witnessed has discouraged the banks

from having any exposure to unsecured consumer credit, and a revival in this segment is not expected to happen soon. According to a research report from Tata Securities, retail loans showed a CAGR of 22% during FY05-FY09. Within the retail segment, housing loans grew by 20% CAGR during the same period and consisted ~10% of the total bank credit. Besides the favorable condition for liquidity and high bond yield, it is expected that the Net Interest Margin (NIM) will not expand much. The banks need to have higher incremental CD ratio, improvement in spreads and stable yield on investments to improve NIMs. Banks are expected to have a low cost of deposits owing to a stable interest rate scenario and ample liquidity in the system. Another important area which requires critical attention is fee income. In the past few years, fee income has been the major contributor of revenue for private sector banks. Thus, we can very well say that the current situation has provided a lot of opportunities and challenges to the existing banks. Now, it is up to the banks as to how well they leverage the opportunities to meet the challenges to the best of their capacities. The banking system remains, as always, the most dominant segment of the financial sector. Indian banks continue to build on their strengths under the regulator's watchful eye and hence, have emerged stronger. In the annual international ranking conducted by UK-based Brand Finance Plc, 18 Indian banks have been included in the Brand Finance Global Banking 500. In fact, the State Bank of India (SBI) which is the first Indian bank to be ranked among the Top 50 banks in the world, has improved its position from 36th to 34th, as per the Brand Finance study released on February 1, 2011. The brand value of SBI has enhanced to US$ 1,119 million. ICICI Bank, the only other Indian bank in the top 100 club has improved its position with a brand value of US$ 2,501 million. According to the study, Indian banks contributed 1.7 per cent to the total global brand value at US$ 14,741 million and grew by 19 per cent in 2011.