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NON-PERFORMING ASSETS

-
CHALLENGE TO THE PUBLIC SECTOR BANKS

INTRODUCTION

After liberalization the Indian banking sector developed very appreciate. The RBI also
nationalized good amount of commercial banks for proving socio economic services to
the people of the nation. The Public Sector Banks have shown very good performance as
far as the financial operations are concerned. If we look to the glance of the financial
operations, we may find that deposits of public to the Public Sector Banks have increased
from 859,461.95crore to 1,079,393.81crore in 2003, the investments of the Public Sector
Banks have increased from 349,107.81crore to 545,509.00crore, and however the
advances have also been increased to 549,351.16crore from 414,989.36crore in 2003. The
total income of the public sector banks have also shown good performance since the last
few years and currently it is 128,464.40crore. The Public Sector Banks have also shown
comparatively good result. The gross profits of the Public Sector Banks currently
29,715.26crore which has been doubled to the last to last year, and the net profit of the
Public Sector Banks is 12,295,47crore. However, the only problem of the Public Sector
Banks these days are the increasing level of the non performing assets. The non
performing assets of the Public Sector Banks have been increasing regularly year by year.
If we glance on the numbers of non performing assets we may come to know that in the
year 1997 the NPAs were 47,300crore and reached to 80,246crore in 2002. The only
problem that hampers the possible financial performance of the Public Sector Banks is
the increasing results of the non performing assets. The non performing assets impacts
drastically to the working of the banks.

The efficiency of a bank is not always reflected only by the size of its balance sheet but
by the level of return on its assets. NPAs do not generate interest income for the banks,
but at the same time banks are required to make provisions for such NPAs from their
current profits.
NPAs have a deleterious effect on the return on assets in several ways –

They erode current profits through provisioning requirements

They result in reduced interest income

They require higher provisioning requirements affecting profits and accretion to capital
funds and capacity to increase good quality risk assets in future, and

They limit recycling of funds, set in asset-liability mismatches, etc. The RBI has also
tried to develop many schemes and tools to reduce the non performing assets by
introducing internal checks and control scheme, relationship managers as stated by RBI
who have complete knowledge of the borrowers, credit rating system, and early warning
system and so on. The RBI has also tried to improve the securitization Act and SRFAESI
Act and other acts related to the pattern of the borrowings. Though RBI has taken number
of measures to reduce the level of the non performing assets the results is not up to the
expectations. To improve NPAs each bank should be motivated to introduce their own
precautionary steps. Before lending the banks must evaluate the feasible financial and
operational prospective results of the borrowing companies. They must evaluate the
business of borrowing companies by keeping in considerations the overall impacts of all
the factors that influence the business.
RESEARCH OPERATION

1. Significance of the study

The main aim of any person is the utilization money in the best manner since the India is
country were more than half of the population has problem of running the family in the
most efficient manner. However Indian people faced large number of problem till the
development of the full-fledged banking sector. The Indian banking sector came into the
developing nature mostly after the 1991 government policy. The banking sector has really
helped the Indian people to utilise the single money in the best manner as they want.
People now have started investing their money in the banks and banks also provide good
returns on the deposited amount. The people now have at the most understood that banks
provide them good security to their deposits and so excess amounts are invested in the
banks. Thus, banks have helped the people to achieve their socio economic objectives.
The banks not only accept the deposits of the people but also provide them credit facility
for their development. Indian banking sector has the nation in developing the business
and service sectors. But recently the banks are facing the problem of credit risk. It is
found that many general people and business people borrow from the banks but due to
some genuine or other reasons are not able to repay back the amount drawn to the banks.
The amount which is not given back to the banks is known as the non performing assets.
Many banks are facing the problem of non performing assets which hampers the business
of the banks. Due to NPAs the income of the banks is reduced and the banks have to
make the large number of the provisions that would curtail the profit of the banks and due
to that the financial performance of the banks would not show good results The main aim
behind making this report is to know how Public Sector Banks are operating their
business and how NPAs play its role to the operations of the Public Sector Banks. The
report NPAs are classified according to the sector, industry, and state wise. The present
study also focuses on the existing system in India to solve the problem of NPAs and
comparative analysis to understand which bank is playing what role with concerned to
NPAs.Thus, the study would help the decision makers to understand the financial
performance and growth of Public Sector Banks as compared to the NPAs.

2. Objective of the study

Primary objective:

The primary objective of the making report is:

To know why NPAs are the great challenge to the Public Sector Banks
Secondary objectives:
The secondary objectives of preparing this report are:

To understand what is Non Performing Assets and what are the underlying reasons for the
emergence of the NPAs.

To understand the impacts of NPAs on the operations of the Public Sector Banks.

To know what steps are being taken by the Indian banking sector to reduce the NPAs?

To evaluate the comparative ratios of the Public Sector Banks with concerned to the
NPAs.

2. Research methodology

The research methodology means the way in which we would complete our prospected
task. Before undertaking any task it becomes very essential for any one to determine the
problem of study. I have adopted the following procedure in completing my report study.
1. Formulating the problem 2. Research design 3. Determining the data sources 4.
Analysing the data 5. Interpretation 6. Preparing research report (1) Formulating the
problem I am interested in the banking sector and I want to make my future in the
banking sector so decided to make my research study on the banking sector. I analysed
first the factors that are important for the banking sector and I came to know that
providing credit facility to the borrower is one of the important factors as far as the
banking sector is concerned. On the basis of the analysed factor, I felt that the important
issue right now as far as the credit facilities are provided by bank is non performing
assets. I started knowing about the basics of the NPAs and decided to study on the NPAs.
So, I chose the topic
“Non Performing Assts the great challenge before the Public Sector Banks”.
(2) Research Design The research design tells about the mode with which the entire
project is prepared. My research design for this study is basically analytical. Because I
have utilised the large number of data of the Public Sector Banks.

(3) Determining the data source The data source can be primary or secondary. The
primary data are those data which are used for the first time in the study. However such
data take place much time and are also expensive. Whereas the secondary data are those
data which are already available in the market. These data are easy to search and are not
expensive too.for my study I have utilised totally the secondary data. (4) Analysing the
data The primary data would not be useful until and unless they are well edited and
tabulated. When the person receives the primary data many unuseful data would also be
there. So, I analysed the data and edited them and turned them in the useful tabulations.
So, that can become useful in my report study. (5) Interpretation of the data With use of
analysed data I managed to prepare my project report. But the analyzing of data would
not help the study to reach towards its objectives. The interpretation of the data is
required so that the others can understand the crux of the study in more simple way
without any problem so I have added the chepter of analysis that would explain others to
understand my study in simpler way. (6) Project writing This is the last step in preparing
the project report. The objective of the report writing was to report the findings of the
study to the concerned authorities.

4. Limitations of the study

The limitations that I felt in my study are:

It was critical for me to gather the financial data of the every bank of the Public Sector
Banks so the better evaluations of the performance of the banks are not possible.

Since my study is based on the secondary data, the practical operations as related to the
NPAs are adopted by the banks are not learned.


Since the Indian banking sector is so wide so it was not possible for me to cover all the
banks of the Indian banking sector.
INDIAN BANKING SECTOR

Banking in India has its origin as early as the Vedic period. It is believed that the
transition from money lending to banking must have occurred even before Manu, the
great Hindu Jurist, who has devoted a section of his work to deposits and advances and
laid down rules relating to rates of interest. During the Mogul period, the indigenous
bankers played a very important role in lending money and financing foreign trade and
commerce. During the days of the East India Company, it was the turn of the agency
houses to carry on the banking business. The General Bank of India was the first Joint
Stock Bank to be established in the year 1786. The others which followed were the Bank
of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued
till 1906 while the other two failed in the meantime. In the first half of the 19
th
century the East India Company established three banks; the Bank of Bengal in 1809, the
Bank of Bombay in 1840 and the Bank of Madras in 1843. These three banks also known
as Presidency Banks were independent units and functioned well. These three banks were
amalgamated in 1920 and a new bank, the Imperial Bank of India was established on 27
th
January 1921. With the passing of the State Bank of India Act in 1955 the undertaking of
the Imperial Bank of India was taken over by the newly constituted State Bank of India.
The Reserve Bank which is the Central Bank was created in 1935 by passing Reserve
Bank of India Act 1934. In the wake of the Swadeshi Movement, a number of banks with
Indian management were established in the country namely, Punjab National Bank Ltd,
Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank of Baroda Ltd, the
Central Bank of India Ltd. On July 19, 1969, 14 major banks of the country were
nationalised and in 15
th
April 1980 six more commercial private sector banks were also taken over by the
government
.
Indian Banking: A Paradigm shift-A regulatory point of view

The decade gone by witnessed a wide range of financial sector reforms, with many of
them still in the process of implementation. Some of the recently initiated measures by
the RBI for risk management systems, anti money laundering safeguards and corporate
governance in banks, and regulatory framework for non bank financial companies, urban
cooperative banks, government debt market and forex clearing and payment systems are
aimed at streamlining the functioning of these instrumentalities besides cleansing the
aberrations in these areas. Further, one or two all India development financial institutions
have already commenced the process of migration towards universal banking set up. The
banking sector has to respond to these changes, consolidate and realign their business
strategies and reach out for technology support to survive emerging competition. Perhaps
taking note of these changes in domestic as well as international arena All of we will
agree that regulatory framework for banks was one area which has seen a sea-change
after the financial sector reforms and economic liberalisation and globalisation measures
were introduced in 1992-93. These reforms followed broadly the approaches suggested
by the two Expert Committees both set up under the chairmanship of Shri M.
Narasimham in 1991 and 1998, the recommendations of which are by now well known.
The underlying theme of both the Committees was to enhance the competitive efficiency
and operational flexibility of our banks which would enable them to meet the global
competition as well as respond in a better way to the regulatory and supervisory demand
arising out of such liberalisation of the financial sector. Most of the recommendations
made by the two Expert Committees which continued to be subject matter of close
monitoring by the Government of India as well as RBI have been implemented.
Government of India and RBI have taken several steps to :- (a) Strengthen the banking
sector, (b) Provide more operational flexibility to banks, (c) Enhance the competitive
efficiency of banks, and (d) Strengthen the legal framework governing operations of
banks.

Regulatory measures taken to strengthen the Indian Banking sectors

The important measures taken to strengthen the banking sector are briefly, the following:

Introduction of capital adequacy standards on the lines of the Basel norms,

prudential norms on asset classification, income recognition and provisioning,

Introduction of valuation norms and capital for market risk for investments

Enhancing transparency and disclosure requirements for published accounts ,

Aligning exposure norms – single borrower and group-borrower ceiling – with inter-
national best practices

Introduction of off-site monitoring system and strengthening of the supervisory
framework for banks. (A) Some of the important measures introduced to provide more
operational flexibility
to banks are:

Besides deregulation of interest rate, the boards of banks have been given the authority to
fix their prime lending rates. Banks also have the freedom to offer variable rates of
interest on deposits, keeping in view their overall cost of funds.

Statutory reserve requirements have significantly been brought down.

The quantitative firm-specific and industry-specific credit controls were abolished and
banks were given the freedom to deploy credit, based on their commercial judgment, as
per the policy approved by their Boards.

The banks were given the freedom to recruit specialist staff as per their requirements,

The degree of autonomy to the Board of Directors of banks was substantially enhanced.

Banks were given autonomy in the areas of business strategy such as, opening of
branches / administrative offices, introduction of new products and certain other
operational areas. (b) Some of the important measures taken to increase the
competitive efficiency
of banks are the following:

Opening up the banking sector for the private sector participation.


Scaling down the shareholding of the Government of India in nationalised banks and of
the Reserve Bank of India in State Bank of India. (c) Measures taken by the Government
of India to provide a more conducive
legal environment
for recovery of dues of banks and financial institutions are:

Setting up of Debt Recovery Tribunals providing a mechanism for expeditious loan
recoveries.

Constitution of a High Power Committee under former Justice Shri Eradi to suggest
appropriate foreclosure laws.

An appropriate legal framework for securitisation of assets is engaging the attention of
the Government, Due to this paradigm shift in the
regulatory framework
for banks had achieved the desired results. The banking sector has shown considerable
degree of resilience. (a) The level of capital adequacy of the Indian banks has improved:
the CRAR of public sector banks increased from an average of 9.46% as on March 31,
1995 to 11.18% as on March 31, 2001. (b) The public sector banks have also made
significant progress in enhancing their asset quality, enhancing their provisioning levels
and improving their profits.

The gross and net NPAs of public sector banks declined sharply from 23.2% and 14.5%
in 1992-93 to 12.40% and 6.7% respectively, in 2000-01.

Similarly, in regard to profitability, while 8 banks in the public sector recorded operating
and net losses in 1992-93, all the 27 banks in the public sector showed operating profits
and only two banks posted net losses for the year ended March 31, 2001.

The operating profit of the public sector banks increased from Rs.5628 crore as on March
31, 1995 to Rs.13,793 crore as on March 31, 2001.

The net profit of public sector banks increased from Rs.1116 crore to Rs.4317 crore
during the same period, despite tightening of prudential norms on provisioning against
loan losses and investment valuation. The accounting treatment for impaired assets is
now closer to the international best practices and the final accounts of banks are
transparent and more amenable to meaningful interpretation of their performance.

WAY FORWARD

RBI president recently recommended Indian banks to go for larger provisioning when
the profits are good without frittering them away by way of dividends, however tempting
it may be. As a method of compulsion, RBI has recently advised banks to create an
Investment Fluctuation Reserve upto 5 per cent of the investment portfolio to protect the
banks from varying interest rate regime. He further added that one of the means for
improving financial soundness of a bank is by enhancing the provisioning standards of
the bank. The cumulative provisions against loan losses of public sector banks amounted
to a mere 41.67% of their gross NPAs for the year ended March 31, 2001. The amount of
provisions held by public sector banks is not only low by international standards but there
has been wide variation in maintaining the provision among banks. Some of the banks in
the public sector had as low provisioning against loan losses as 30% of their gross NPAs
and only 5 banks had provisions in excess of 50% of their gross NPAs. This is inadequate
considering that some of the countries maintain provisioning against impaired assets at as
high as 140%. Indian Banks should improve the provisioning levels to at least 50% of
their gross NPAs. There should therefore be an attitudinal change in banks’ policy as
regards appropriation of profits and full provisioning towards already impaired assets
should become a priority corporate goal. He also suggested that banks should also
develop a concept of building
desirable capital
over and above

the minimum CRAR
which is insisted upon in developed regulatory regimes like UK. This can be at, say
around 12 percent as practised even today by some of the Indian banks, so as to provide
well needed cushion for growth in risk weighted assets as well as provide for unexpected
erosion in asset values. As banks would have observed, the changes in the regulatory
framework are now brought in by RBI only through an extensive consultative process
with banks as well as public wherever warranted. While this serves the purpose of impact
assessment on the proposed measures it also puts the banks on notice to initiate
appropriate internal readjustment to meet the emerging regulatory prescriptions. Though
adequate transitional route has been provided for switchover to new regulatory measures
such as scaling down the exposure to capital market, tightening the prudential
requirements like switch over to 90 day NPA norm, reduction in exposure norms, etc., I
observe from the various quarters

from which RBI gets its inputs that the banks are yet to take serious steps towards
implementation of these measures. The Boards of banks have been accorded
considerable autonomy in regard to their corporate strategy as also several other
operational matters. This does not; however, seem to have translated to any substantial
improvement in customer service. It needs to be recognised that meeting the requirements
of the customer – whether big or small – efficiently and in a cost

effective manner, alone will enable the banks to withstand the global competition as also
the competition from non-bank institutions. The profitability of the public sector banks is
coming under strain. Despite the resilience shown by our banks in the recent times, the
income from recapitalisation bonds accounted for a significant portion of the net profits
for some of the nationalised banks. The Return on Assets (RoA) of public sector banks
has, on an average, declined from 0.54 for the year ended March 31, 1999 to 0.43 for the
year ended March 31, 2001. Therefore, the Boards’ attention needs to be focused on
improving the profitability of the bank. The interest income of public sector banks as a
percentage of total assets has shown a declining trend since 1996-97: it declined from
9.69 in 1996-97 to 8.84 in 2000-01. Similarly, the spread (net interest income) as a
percentage of total assets also declined from 3.16 in 1996-97 to 2.84 in 2000-01. A
disheartening feature is that a large number of public sector banks have recorded far
below the median RoA of 0.4% for 2000-01 in their peer group. Incidentally the RoA
recorded by new private banks and foreign banks ranged from 0.8% to 1% for the same
period. An often quoted reason for the decline in profitability of public sector banks is the
stock of NPAs which has become a drag on the bank’s profitability. As you are aware, the
stock of NPAs does not add to the income of the bank while at the same time, additional
cost is incurred for keeping them on the books. To help the public sector banks in clearing
the old stock of chronic NPAs, RBI had announced ‘one-time non discretionary and non
discriminatory compromise settlement schemes’ in 2000 and 2001. Though many banks
tried to settle the old NPAs through this transparent route, the response was not to the
extent anticipated as the banks had been bogged down by the usual fear psychosis of
being averse to settling dues where security was available. The moot point is if the
underlying security was not realised over decades in many cases due to extensive delay in
litigation process, should not the banks have taken advantage of the one time opportunity
provided under RBI scheme to cleanse their books of chronic
NPAs? This would have helped in realizing the carrying costs on such non-income
earning NPAs and released the funds for recycling. If better steps are taken placed in this
connection then the performance of the Public Sector Banks can show very good and
healthy results in the shorter period. To make the better future of the Public Sector Banks,
the Boards need to be alive to the declining profitability of the banks. One of the reasons
for the low level of profitability of public sector banks is the high operating cost. The cost
income ratio (which is also known as efficiency ratio of public sector banks) increased
from 65.3 percent for the year ended March 31, 2000 to 68.7 per cent for the year ending
March 31, 2001. The staff expenses as a proportion to total income formed as high as
20.7% for public sector banks as against 3.3% for new banks and 8.2% for foreign banks
for the year ended March 31, 2001. There is thus an imperative need for the banks to go
for cost cutting exercise and rationalise the expenses to achieve better efficiency levels in
operation to withstand declining interest rate regime. Boards of banks have much more
freedom now than they had a decade ago, and obviously they have to play the role of
change agents. They should have the expertise to identify, measure and monitor the risks
facing the bank and be capable to direct and supervise the bank’s operations and in
particular, its exposures to various sectors of the economy, and monitoring / review
thereof, pricing strategies, mitigation of risks, etc. The Board of the banks should also
ensure compliance with the regulatory framework, and ensure adoption of the best
practices in regard to risk management and corporate governance standards. The
emphasis in the second generation of reforms ought to be in the areas of risk management
and enhancing of the corporate governance standards in banks.
THE INDIAN BANKING INDUSTRY

The origin of the Indian banking industry may be traced to the establishment of the Bank
of Bengal in Calcutta (now Kolkata) in 1786. Since then, the industry has witnessed
substantial growth and radical changes. As of March 2002, the Indian banking industry
consisted of 97 Commercial Banks, 196 Regional Rural Banks, 52 Scheduled Urban Co-
operative Banks, and 16 Scheduled State Co-operative Banks. The growth of the banking
industry in India may be studied in terms of two broad phases: Pre Independence (1786-
1947), and Post Independence (1947 till date). The post independence phase may be
further divided into three sub-phases:

Pre-Nationalisation Period (1947-1969)

Post-Nationalisation Period (1969-1991)

Post-Liberalisation Period (1991- till date) The two watershed events in the
postindependence phase are the nationalisation of banks (1969) and the initiation of the
economic reforms (1991). This section focuses on the evolution of the banking industry
in India post-liberalisation.
1. Banking Sector Reforms - Post-Liberalisation
In 1991, the Government of India (Gol) set up a committee under the chairmanship
of Mr. Narasimaham to make an assessment of the banking sector. The report of this
committee contained recommendations that formed the basis of the reforms initiated in
1991. The banking sector reforms had the following objectives: 1. Improving the
macroeconomic policy framework within which banks operate; 2. Introducing prudential
norms; 3. Improving the financial health and competitive position of banks; 4. Building
the financial infrastructure relating to supervision, audit technology and legal
framework; and 5. Improving the level of managerial competence and quality of human
resources.
1.1 Impact of Reforms on Indian Banking Industry

With the initiation of the reforms in the financial sector during the 1990s, the operating
environment of banks and term-lending institutions has radically transformed. One of the
fall-outs of the liberalisation was the emergence of nine new private sector banks in the
mid1990s that spurred the incumbent foreign, private and public sector banks to compete
more fiercely than had been the case historically. Another development of the economic
liberalisation process was the opening up of a vibrant capital market in India, with both
equity and debt segments providing new avenues for companies to raise funds. Among
others, these two factors have had the greatest influence on banks operating in India to
broaden the range of products and services on offer. The reforms have touched all aspects
of the banking business. With increasing integration of the Indian financial markets with
their global counterparts and greater emphasis on risk management practices by the
regulator, there have been structural changes within the banking sector. The impact of
structural reforms on banks' balance sheets (both on the asset and liability sides) and the
environment they operate in is discussed in the following sections.
1.2 Reforms on the Liabilities Side


Reforms of Deposit Interest Rate
Beginning 1992, a progressive approach was adopted towards deregulating the interest
rate structure on deposits. Since then, the rates have been freed gradually. Currently, the
interest rates on deposits stand completely deregulated (with the exception of the savings
bank deposit rate). The deregulation of interest rates has helped Indian banks to gain
more control on the cost of their deposits, the main source of funding for Indian banks.
Besides, it has given more, flexibility to banks in managing their Asset-Liability
positions.


Increase in Capital Adequacy Requirement
During the 1990s, the Reserve Bank of India (RBI) adopted a strategy aimed at all
banks attaining a Capital Adequacy Ratio (CAR) of 8% in a phased manner. On the
recommendations of the Committee on Banking Sector Reforms, the minimum CAR was
further raised to 9%, effective March 31, 2000.While the stipulation of a higher Capita!
Adequacy' Ratio has increased the capital requirement of banks; it has provided more
stability to the Indian banking system.
1.3 Reforms on the Asset Side

Reforms on the Lending Interest Rate
During 1975-76 to 1980-81, the RBI prescribed both the minimum lending rate and the
ceiling rate. During 1981-82 to 1987-88. The RBI prescribed only the ceiling rate. During
198889 to 1994-95, the RBI switched from prescribing a ceiling rate to fixing a minimum
lending rate. From 1991 onwards, interest rates have been increasingly freed. At present,
banks can offer loans at rates below the Prime Lending Rate (PLR) to exporters or other
creditworthy borrowers (including public enterprises), and have only to announce the
FLR and the maximum spread charged over it. The deregulation of lending rates has
given banks the flexibility to price loan products on the basis of their own business
strategies and the risk profile of the borrower. It has also lent a competitive advantage to
banks with lower cost of funds.

Lower Cash Reserve and Statutory Liquidity Requirements
During the early 1980s, statutory pre-emption in the form of Cash Reserve Ratio (CRR)
and Statutory Liquidity Ratio (SLR) accounted for 42% of the deposits. In the 1990s, the
figure rose to 53.5%, which during the post-liberalisation period has been gradually
reduced. At present, banks are required to maintain a CRR of 4% of the Net Demand and
Time Liabilities (NDTL) (excluding liabilities subject to zero CRR prescriptions). The
RBI has indicated that the CRR would eventually be brought down to the statutory
minimum level of 3% over a period of time. The SLR, which was at a peak of 38.5%
during September 1990 to December 1992, now stands lower at the statutory minimum of
25%.A decrease in the CRR and SLR requirements implies an increase in the share of
deposits available to banks for loans and advances. It also means that bank's now have
more discretion in the allocation offunds, which if deployed efficiently, can have a
positive impact on their profitability. By increasing the amount of invisible funds
available to banks, the reduction in the CRR and SLR requirements has also enhanced the
need for efficient risk management systems in banks.


Asset Classification and Provisioning Norms
Prudential norms relating to asset classification have been changed post-liberalisation.
The earlier practice of classifying assets of different quality into eight `health codes" has
now been replaced by the system of classification into four categories (in accordance
with the international norms): standard, sub-standard, doubtful, and loss assets. On 1st
April 2000, provisioning requirements of a minimum of 0.25% were introduced for
standard assets. For the sub-standard, doubtful and loss asset categories, the provisioning
requirements remained at 10%, 20-50% (depending on the duration for which the asset
has remained doubtful), and 100%, respectively, the recognition norms for NPAs have
also been tightened gradually. Since March 1995, loans with interest and/or installment of
principal overdue for more than 180 days are classified as non-performing. This period
will be shortened to 90 days from the year ending 31st' March 2004.
1.4 Structural Reforms


Increased Competition
With the initiation of banking-sector reforms, a more competitive environment has been
ushered in. Now banks are not only competing within themselves, but also with non-
banks, such as financial services companies and mutual funds. While existing banks have
been allowed greater flexibility in expanding their operations, new private sector banks
have also been allowed entry. Over the last decade nine new private sector banks have
established operations in the country. Competition amongst Public Sector Banks (PSBs)
has also intensified. PSBs are now allowed to access the capital market to raise funds.
This has diluted Government's shareholding, although it remains the major shareholder in
PSBs, holding a minimum 51% of their total equity. Although competition in the banking
sector has reduced the share of assets and deposits of the PSBs, their dominant positions,
especially of the large ones, continues. Although the PSBs will remain major players in
the banking industry, they are likely to face tough competition, from both private sector
banks and foreign banks. Moreover, the banking industry is likely to face stiff
competition from other players like non-bank

finance companies, insurance companies, pension funds and mutual funds. The increasing
efficiency of both the equity and debt markets has also accelerated the process of
financial disintermediation, putting additional pressure on banks to retain their customers.
Increasing competition among banks and financial intermediaries is likely to reduce the
Net Interest Spread of banks.


Banks entry into New Business Lines
Banks are increasingly venturing into new areas, such as, Insurance and Mutual Funds,
and offering a wider bouquet of products and services to satisfy the diverse needs of their
customers. With the enactment of the Insurance Regulatory and Development Authority
(IRBA) Act, 1999, banks and NBFCs have been allowed to enter the insurance business.
The RBI has also issued guidelines for-banks' entry into insurance, according to which,
banks need to obtain prior approval of the RBI to enter the insurance business. So far, the
RBI has accorded its approval to three of the 39 commercial banks that had sought entry
into insurance. Insurance presents a new business opportunity for banks. The opening up
of the insurance business to banks is likely to help them emerge as financial supermarkets
like their counterparts in developed countries.

Increased thrust on Banking Supervision and Risk Management
To strengthen banking supervision, an independent Board for Financial Supervision
(BFS) under the RBI was constituted in November 1994. The Board is empowered to
exercise integrated supervision over all credit institutions in the financial system,
including select Development Financial Institutions (DFIs) and Non Banking Financial
Companies (NBFCs), relating to credit management, prudential norms and treasury
operations. A comprehensive rating system, based on the CAMELS methodology, has
also been instituted for domestic banks; for foreign banks, the rating system is based on
CACS. This rating system has been supplemented by a technology-enabled quarterly off-
site surveillance system. To strengthen the Risk Management Process in banks, in line
with proposed Basel 11 accord, the RBI has issued guidelines for managing the various
types of risks that banks are exposed to. To make risk management an integral part of the
Indian banking system, the RBI has also issued guidelines for Risk based Supervision
(RBS) and Risk based Internal Audit (RBIA).

These reform initiatives are expected to encourage banks to allocate funds across various
lines of business on the basis of their Risk adjusted Return on Capital (RAROC). The
measures would also help banks be in line with the global best practices of risk
management and enhance their competitiveness. The Indian banking industry has come a
long way since the nationalisation of banks in 1969. The industry has witnessed great
progress, especially over the past 12 years, and is today a dynamic sector. Reforms in the
banking sector have enabled banks explore new business opportunities rather than
remaining confined to generating revenues from conventional streams. A wider portfolio,
besides the growing emphasis on consumer satisfaction, has led to the Indian banking
sector reporting robust growth during past few years. It is clear that the deregulation of
the economy and of the Banking sector over the last decade has ushered in competition
and enabled Indian banks to better take on the challenges of globalisation.
1.5 Operational and Efficiency Benchmarking


Benchmarking of Return on Equity
Return on Equity (ROE) is an indicator of the profitability of a bank from the
shareholder's perspective. It is a measure of Accounting Profits per unit of Book Equity
Capital. The ROE of Indian banks for the year ended 31st March 2003, was in the range
of 14 - 40%; the median ROE. Being 23.72% for the same period. On the other hand, the
global benchmark banks had a median ROE of 12.72% for the year ended 31st December
2002. In recent years, Indian banks have reported unusually high trading incomes, driven
mainly by the scope to booking profits that arise from a sharply declining interest rate
environment. However, such high trading income may not be sustainable in future. The
adjusted median ROE for Indian banks (adjusted for trading income) stands at 5.42% for
Indian banks for FY2003 as compared with 11.77% for the global benchmark banks.After
adjusting for trading income, the median ROE of Indian hanks stands lower than the
same for the global benchmark banks, thus implying that the contribution of trading
income to the RoE of Indian banks is significant.

Further, the ROE benchmarking method favors banks that operate with low levels of
equity or high leverage. To assess the impact of the leverage factor on the ROE of banks,
"Equity Multiplier” is presented in the next section.

Benchmarking of Equity Multiplier
Equity Multiplier (EM) is defined as "Total Assets divided by Net Worth". This is the
reciprocal of the Capital-to-Asset ratio, which indicates the leverage of a bank (amount of
Assets of a bank pyramided on its equity capital). Banks with a higher leverage will be
able to post a higher ROE with a similar level of Return on Asset (ROA), because of the
multiplier effect. However, the banking industry is safer with a lower leverage or a higher
proportion of equity capital in the total liability. Capital is important for banks for two
main reasons: Firstly, capital is viewed as the ultimate line of protection against any
potential losscredit, market, or operating risks. While loan and investment provisions are
associated with expected losses, capital is a cushion against unexpected losses. Secondly,
capital allows banks to pursue their growth objectives; a bank has to maintain a minimum
capital adequacy ratio in accordance with regulatory requirements. A bank with
insufficient capital may not be able to take advantage of growth opportunities offered by
the external operating environment the same way as another bank with a higher capital
base could.

Benchmarking of Return on Assets
ROA is defined as Net Income divided by Average Total Assets. The ratio measures a
bank's Profits per currency unit of Assets. The median ROA for Indian banks was 1.15%
for FY2003. For the global benchmark banks, the ROA ranged from 0.05% to 1.44% for
the year ended December 2002, with the median at 0.79%. For the year ended December
2002, Bank of America reported the highest ROA (1.44%) among the global benchmark
banks, followed by Citi group Inc. (1.42%). The median value for Indian banks at 1.15%
was higher than that of ABN AMRO Bank, Deutsche Bank, Rabo Bank and Standard
Chartered Bank. Two banks, namely Bank of America and Citigroup Inc., posted higher
ROAs as compared with the European and other banks for both FY2003 and FY2002
primarily on the strength of higher Net Interest Margins. The reasons for the Net Interest
Margins being higher are discussed in the sections that follow.

As with the ROE analysis, here too adjustments for non-recurring income/expenses must
be made while comparing figures on banks' ROA. Adjusting for trading income, for both
Indian banks and the global benchmark banks, the median works out to be lower for
Indian banks vis-a-vis the global benchmark banks for FY 2003. I have further analysed
the effect of adjustment for trading income on the ROAs of both Indian Banks and the
Global Benchmark Banks. Here, it must be noted that the global benchmark banks have a
more diversified income portfolio as compared with Indian banks, and a decline in
interest rate could have increased profitability of global benchmark banks indirectly in
more ways than one. However, from the disclosures available in the annual reports of the
global banks, it is not possible to quantify the impact of declining interest rates on their
profitability (`thus, the same has not been adjusted for in this analysis). Nevertheless, to
further analyse the profitability (per unit of assets) of Indian banks vis-a-vis the global
benchmark banks, ICRA has conducted a ROA decomposition analysis.
1.6 Decomposition of Return on Assets

Net Interest Margin
Net Interest Margin (NIM) measures the excess income of a bank's earnings assets
(primarily loans, fixed-income investments, and interbank exposures) over its funding
costs. To the past, for banks NIM was the main source of earnings, which were therefore
directly correlated with the margin levels. But with NIM declining significantly in many
countries, banks are now trying to compensate the "lost" margins with non-fund based fee
incomes and trading income. Despite these changes, net interest income continues to
account for a significant share of the earnings of most banks. The median NIM for Indian
banks was 3.16% for FY2003 and 3.92% for FY2002. The figures compare favorably
with those of the global benchmark banks. Before drawing inferences on the NIM
benchmarking results, three aspects must be considered, namely: (a) The external
operating environment, (b) The quality and type of assets, and (c) Accounting policies
followed by banks. The three aspects are explored in detail in the subsequent paragraphs.
(a) External Operating Environment