Future of Banking in India – Changing Imperatives

RISK MANAGEMENT AND BASEL II

The future of banking will undoubtedly rest on risk management dynamics. Only those
banks that have efficient risk management system will survive in the market in the long
run. The effective management of credit risk is a critical component of comprehensive
risk management essential for long-term success of a banking institution.

Although capital serves the purpose of meeting unexpected losses, capital is not a
substitute for inadequate decontrol or risk management systems. Coming years will
witness banks striving to create sound internal control or risk management processes.
With the focus on regulation and risk management in the Basel II framework gaining
prominence, the post-Basel II era will belong to the banks that manage their risks
effectively. The banks with proper risk management systems would not only gain
competitive advantage by way of lower regulatory capital charge, but would also add
value to the shareholders and other stakeholders by properly pricing their services,
adequate provisioning and maintaining a robust financial structure.

‘The future belongs to bigger banks alone, as well as to those which have minimised their
risks considerably.’

CONSOLIDATION

Consolidation, which has been on the counter over the last year or so, is likely to gather
momentum in the coming years. Post April 2009, when the restrictions on operations of
foreign banks will go, the banking landscape is expected to change dramatically. Foreign
banks, which currently account for 5% of total deposits and 8% of total advances, are
devising new business models to capture the Indian market. Their full-fledged entry is
expected to transform the business of banking in many ways, which would be reflected in
terms of greater breadth of products, depth in delivery channels and efficiency in
operations.

Thus Indian banks have less than three years to consolidate their position. Despite the stiff
resistance from certain segments, consolidation holds the key to future growth. This view
is underpinned by the following:
► Owing to greater scale and size, consolidation can help save costs and improve
operational efficiency.
► Banks will also have to explore different avenues for raising capital to meet norms
under Basel-II
► Owing to the diversified operations and credit profiles of merging banks, consolidation
is likely to serve as a risk-mitigation exercise as much as a growth engine.

Though there is no confirmation yet, speculative signals arising from the market point to
the prospect of consolidation involving banks such as Union Bank of India, Bank of India,
Bank of Baroda, Dena Bank, State Bank of Patiala, and Punjab and Sind Bank. Further,
the case for merger between stronger banks has also gained ground — a clear deviation
from the past when only weak banks were thrust on stronger banks. There is a case being
made for mergers between banks with a distinct geographical presence coming together to
leverage their respective strengths.

GLOBALIZATION/ OVERSEAS EXPANSION

Growing integration of economies and the markets around the world is making global
banking a reality. The surge in globalization of finance has already begun to gain
momentum with the technological advancements which have effectively overcome the
national borders in the financial services business. Widespread use of internet banking
will widen frontiers of global banking, and make marketing of financial products and
services on a global basis possible. In the coming years globalization will spread further
on account of the likely opening up of financial services under WTO. India is one of the
104 signatories of Financial Services Agreement (FSA) of 1997. This gives India’s
financial sector including banks an opportunity to expand their business on a quid pro quo
basis.

As per Indian Banks' Association report ‘Banking Industry Vision 2010’, there would be
greater presence of international players in Indian financial system and some of the Indian
banks would become global players in the coming years. So, the new mantra for Indian
banks is to go global in search of new markets, customers and profits.

TECHNOLOGY

There is an imperative need for not mere technology upgradation but also its integration
with the general way of functioning of banks to give them an edge in respect of services
provided to their constituents, better housekeeping, optimizing the use of funds and
building up of MIS for decision making, better management of assets & liabilities and the
risks assumed which in turn have a direct impact on the balance sheets of banks as a
whole. Technology has demonstrated potential to change methods of marketing,
advertising, designing, pricing and distributing financial products and services and cost
savings in the form of an electronic, self-service product delivery channel. These
challenges call for a new, more dynamic, aggressive and challenging work culture to meet
the demands of customer relationships, product differentiation, brand values, reputation,
corporate governance and regulatory prescriptions. Technology holds the key to the future
success of Indian Banks.

Internet, wireless technology and global straight-through processing have created a

paradigm shift in the banking industry. The explosive growth of both the Internet and
mobile and wireless technology is revolutionizing the way the financial industry conducts
business. The overall wireless technology market is expected to grow profoundly in the
coming years.

REGULATIONS

The RBI's approval for banks to raise funds abroad through innovative capital instruments
holds great significance. Such fund-raising, which includes preference shares, will,
however, not just substitute equity; it could have unintended consequences on the
strategies of banks and their profitability. While the cost of raising monies through such
instruments is likely to be higher (close to 10 per cent), the consequent higher leverage on
equity funds is likely to result in expansion of return on net worth. This is because the
same amount of capital supports a higher volume of business, generating higher profits.
Banks are likely to be able to raise long-term preference shares at coupon rates between
six per cent and eight per cent. The positive impact on bank profitability could thus be
significant.
Preference capital can be used as the currency for acquisition. The advantage for public
sector banks is that they no longer need to bother about government stake falling below 51
per cent. Banks such as Dena Bank, Oriental Bank of Commerce and Andhra Bank are
most likely to benefit from this move.

SKILLED MANPOWER

There will be a sea change for employees too. Secure jobs will be replaced by contractual
appointments, for a specified period of time. The unions will merge into the shadows and
bank managements will turn effective. As a result there will be swifter turn over of
personnel in banks. But at the same time, skilled personnel from other disciplines will
enter banks in increasing numbers.
Factors like skills, attitudes and knowledge of the human capital play a crucial role in
determining the competitiveness of the financial sector. The quality of human resources
indicates the ability of banks to deliver value to customers. Capital and technology are
replicable but not the human capital which needs to be valued as a highly valuable
resource for achieving that competitive edge.

Business model, which comprises a comprehensive range of business solutions delivered

through a unique balance of portfolio and relationship management must be incorporated.

FUTURE CHALLENGES & SUGGESTIONS

Challenges
►Competition
►Customer Retention
►Globalization
►Shrinking Margin

Suggestions
►Strong In-house research & market Intelligence
►Focused marketing- Focus on region-specific campaigns rather than national media
campaigns

The growth of the retail financial services sector has been a key development on the
market front. Indian banks (both public and private) will not only be keen to tap the
domestic market but also to compete in the global market place. New foreign banks will
be equally keen to gain a foothold in the Indian market.

CONCLUSION:

What will the future of Indian banking and insurance look like? Will the reform in
banking and insurance sectors face the same fate as in power and telecom? It is
increasingly evident that the economy offers opportunities but no security! Therefore, the
future will belong to those who develop good internal controls, checks and balances and a
sound market strategy. Business Growth, Cost Efficiency and Evolution are therefore
regarded as key drivers which will have to be addressed.

Future of banking and insurance

R. Parthasarathy

REFORMING the financial sector is central to second-generation reforms. This covers

three important segments -- banking, insurance and the capital market. Some
reform has already taken place in the capital market, though strengthening the
institutional m echanism to prevent unethical practices is receiving the Government's
attention. The latest to be opened up for private investment, including foreign direct
investment, is the insurance sector.

On a rough reckoning, commercial bank deposits account for 25 per cent of GDP and
credit extended by banks may be 15 per cent of GDP. This leaves out transactions by
industrial financial institutions, non-banking financial companies, cooperative banks,
d eposits in public provident funds treasury payments some of which may be agency
functions of the banks. Thus, regular bank credit transactions alone account for a
substantial percentage of GDP by way of servicing economic activities.

A gradual convergence is taking place in the banking and insurance sectors. Several
major banks are floating subsidiaries to enter both life and non-life insurance
businesses. Some of them are looking at niche markets such as corporate insurance.
There a re reports that Tata-AIG will be launching ``Mobile Claims Service'' in four
metros and Bangalore and Hyderabad for quick settlement of customer claims. SBI,
in collaboration with Cardiff of France, is planning to enter life insurance.
Features common to both sectors are financial discipline, regulatory framework and
prudential norms in investment management. Given the kind of convergence taking
place, there is need for closer institutionalised cooperation among the RBI, Insurance
Regu latory and Development Authority of India (IRDA) and the Securities Exchange
Board of India. A single regulatory authority is unfeasible. This has also been the
experience of Canada, the US, the UK and Germany.

The banking sector has been undergoing reforms for over a decade now based
largely on the report of the Narasimham Committee on Bank Reforms. Considerable
progress has been made in the gradual reduction of non-performing assets of banks
which stood at al arming 12-15 per cent six or seven years ago. It is now around 7
per cent on net basis.

Reform of the insurance sector began with the decision to open up this sector for
private participation with foreign insurance companies being allowed entry with a
maximum of 26 per cent capital investment. The major step, however, was the
passing of the Insurance Regulatory Authority Act, 1999 on April 20, 2000. With this,
14 companies in life insurance and nine in non-life insurance have been given
permission by the IRDA so far, and within the next one year this figure may go up to
30.

Innovative products and ethics in marketing

The future will offer a wider choice for policy-holders, with innovative products to suit
particular needs. But as often is said, insurance policies are sold and not bought.
This means ethical marketing practices must be strictly observed and enforced. D
eceptive packaging of policies or misleading advertisements should attract stern
penalties. This is one area of focus for corporate governance and insurers must self-
regulate this activity by evolving a code of ethics in marketing.

Some of the major areas where IRDA has made regulations or issued guidelines are
analysed below:

* Actuarial report, abstract and role of appointed actuary: This is a key reporting
document which, if truthfully executed, will bring out the true state of affairs of the
business. In the life insurance business, a key person in the system of supervisio n is
the appointed actuary for which a separate provision exists in IRDA regulations.

The actuary has a wide range of responsibilities, especially to determine reserves,

and to ensure the continuing viability of the insurance products and projecting a true
and fair picture of the company's financial affairs. This will, thus, constitute a major
area of corporate governance.

* Obligations of insurers to rural and social sectors: A minimum percentage starting

from 5 per cent and going up to 12 per cent, of total insurance must be set apart for
rural and social sectors, with stipulation on the number of lives to be insured in order
to increase penetration. This should motivate insurers to innovate products best
suited for weaker sections of society and the rural segment of the population.

Under Indian conditions, the innovative capability of the insurer will be fully tested in
coming up with suitable products to suit different socio-economic strata. Currently,
benchmark statistics on claims settlement or cost/benefit analysis may not be r
eadily available. But considering the gradual rise in rural incomes and existence of
insurable risks, the rural sector will provide greater opportunities.

* Insurance advertisements and disclosures: This is an important area for sharing

information, not only with the insurance regulatory authority but also policy-holders
and share-holders. This will be a key area of corporate governance. The IRDA has
guide lines to help insurance companies adhere to norms.

* Licensing of insurance agents: In the insurance business, most selling takes place
through tied agents, and companies tend to launch lavish and aggressive campaigns
that raise commissions and selling costs. There could be a multiplicity of distribution
channels -- bankassurance, corporate bodies and independent brokers. The agent's
role in life insurance is particularly important.

In the US, a tied agency is generally the norm. Tied agents, being sales persons for
individual companies, are governed by company standards and products on offer,
while an independent broker may have wider access to products of different
companies, depe nding on specific consumer needs. Also, competition among
companies may not be only in respect of services offered, but also with reference to
special features of products.

Currently, in India with LIC and the erstwhile subsidiaries of General Insurance
Corporation (GIC) having near monopoly position, there can only be tied agencies.
But what about the future? With the emergence of several new players, should there
be tied agents and brokers with multiple affiliations? These issues need to be
considered.

* General insurance -- reinsurance: General insurance in India is more focussed on

industry and commercial enterprises with emphasis on fire, theft risks and property
damage. While the four subsidiaries of GIC will focus on general insurance, GIC itself
will function as a reinsurer under the new dispensation. Despite the vast untapped
market potential, health insurance has not attracted as much attention as other
forms of business. Perhaps, some life insurance companies may have plans of part
coverage o f health under their schemes. Vehicle insurance is another major area of
general insurance activity.

Marine insurance will increasingly become important, but at present, there are
established international players in this field, such as Lloyds, UK.

Technology brings its own demands. For instance, with the emergence of information
technology, new areas of risk coverage will come to the fore. Also, product liability
and professional risk coverage schemes which are relatively new in the Indian
context may emerge as insurable risks. Proper risk analysis and internal guidelines
within companies in regard to these new forms of business will be important and
necessary functions of corporate governance.

* Assets, liabilities and solvency margin of insurers: Valuation of assets and

provision for liabilities should be done realistically. International practices in this
matter differ widely. Unrealised investment gains may not be reflected in the profit-
an d-loss account and, thus, cannot form the basis of determining distributable
profits. This is a prudent and one conservative accounting practice. On the contrary,
in the UK, companies have the freedom to choose market value, historical cost or a
value be tween the two. The conservative approach might seem better suited to the
Indian conditions, given the volatility of investment markets and the nascent state of
the insurance industry under competitive conditions. The IRDA, according to press
reports, rec ently relaxed the norms for investments for new entrants in rated
securities. The Regulator has also permitted `+A' rated instruments instead of the
earlier `AA'.

The problem of availability of instruments with higher ratings must be recognised at

a time when the capital market is witnessing listless conditions. The question that
needs to be addressed is to what extent investment in offshore debt instruments
may b e allowed, and what should be the criteria for such investments? Already,
mutual funds are allowed to invest in offshore instruments.

This also stresses the need for more prudent management of investments of funds.
In India, general insurance companies have more freedom of investment of surplus
funds. Forty five per cent of their investments, compared to 75 per cent in the case
of LIC, come under ``directed investments''. On the contrary, control of expenditure
is better in life insurance, compared to general insurance, mainly because leakages
in general insurance are higher. Despite such differences, the free reserve position of
LIC is poor.

Regarding solvency margins, there are two approaches. One is fixing of premiums at
levels that may be adequate to pay for future claims and avoid insolvencies. The
other approach is solvency monitoring. Normally, one would prefer the second
method as it leaves flexibility in the hands of insurers to fix premia for specific
policies, particularly in the context of emerging competition and product
differentiation.

* Condition of service of officers and other employees: Manpower planning and

training will be crucial to successful operation of business, particularly in the
competitive environment. Of the population of more than one billion, those covered
by some for m of insurance or the other may be around 40 million. According to one
estimate, the potential market is about 200-250 million, with an annual growth rate
of 15 per cent.

* Insurance surveyors and loss assessors: Insurance surveyors and loss assessors
are an important link in the insurance business, particularly in general insurance,
where assessing the insurable risk and premium of the property to be insured and,
subsequ ently, in the event of a claim settlement arising, assessing the amount of
settlement may determine the loss or gain to the insurer from such a transaction.

What about the future?

What will the future of Indian banking and insurance look like? Will the reform in
banking and insurance sectors face the same fate as in power and telecom? It is
increasingly evident that the economy offers opportunities but no security!
Therefore, the future will belong to those who develop good internal controls, checks
and balances and a sound market strategy.
The finance ministry has a new incumbent and the hope all round seems to be that he will
try and improve the feel good factor. While wishing the new finance minister the best in
his endeavour, I would request him to resist the temptation of tinkering with the financial
system or key organisations in it with a view to merely creating an illusion of economic
well being. The tendency to make marginal changes in a random manner is pervasive in
this country resulting in creating incomplete systems and inchoate organisations. The
financial sector is a case in point with a large number of knee-jerk reactions to scams or
systemic failures. It is important to understand that sometimes inaction may be better than
thoughtless hasty action. This applies as much to organisational change as it does to
sector level changes.

The financial sector has witnessed changes in many respects. Banking has seen many
changes in the last two decades, as has the mutual fund business. During the first three
decades after independence, the financial sector and changes in it were largely dominated
by SBI, IDBI, IFCI, UTI, ICICI, and LIC but the last two decades saw a significant
contribution by many other players, smaller in size, but faster on their feet. Each one of
these large players was created with very specific mandates, but with sector-wide
responsibilities. For example formation of SBI was the result of the Rural Credit Survey
Committee recommendation to create an entity that among other things, would help the
government in stimulating banking in the entire country. Similarly, the UTI was created
in 1964 with the explicit objective of stimulating investment in the stock market. In other
words, these organisations were created with specific purposes and a vision for the future.
They have significantly served the purposes that drove them all these years, and delivered
on the agenda set for them. The present day financial sector has been built on the
achievements of these organisations. However, in the last few years, we see organisations
like SBI and UTI endeavouring to compete with every player in the market. As a
consequence, these organisations are trying to become everything to everybody. The
negative image associated with a public enterprise has only added to their attempt to
emulate private enterprise behaviour. Survival has become the objective of these
pioneers. In sum, these organisations are fast losing their initial identity without gaining a
new one! These organisations are trying to respond by tinkering with their organisation
design or by changing the ownership pattern. Such interventions are likely to be
inappropriate given the status of these organisations. A comprehensive relook at the
existence of these organisations is an imperative. They will have to introspect on their
relevance in the present context. For example, SBI will have to contemplate on the role it
can play in the market given the state of the market today and a desirable state in the
future. Similarly, UTI may have to examine its role in the mutual fund sector.

Organisations, which have played defining roles in economies, have often found
themselves at such crossroads because they reach there first. The genius of the
organisation is in identifying the moment as such and in reinventing itself to play a
similar pivotal role again although in a different context. AT&T was one such
organisation, which during the early seventies went through an elaborate exercise of
reinventing itself for the future state of communications business that it envisioned. The
task was not just about being prepared for the future but about preparing to shape the
future of the industry. The major players of the financial markets in India will have to do
something similar; they need to envision the desirable future state of the market and
define their role in shaping the future. This would mean playing a pioneering role once
again in a new context; any other role would probably be insignificant for these
organisations. The finance ministry as the de facto owner of these organisations needs to
encourage their managements to undertake this critical task immediately.

Wondering about the future of the Indian economy? Is the boom in the job market
superficial? Well, nobody has an answer to that but what we know is that currently
India is short of a million employees in Financial services and IT sectors.

The Retail Banking is witnessing a 30 % Growth in India, with the top banks
experiencing a rise as much of 70%. Insurance is growing by 50%, Mutual Funds
growing by 33%, Credit Cards by 35%. Today Banking sector employs about 900000
people and with full reforms it can employ 15, 00,000 people. However one of the
crucial impediments to growth for this sector is the acute shortage of manpower
talent of this specific nature.

Further, India can grab jobs from other countries. A.T. Kearney Inc. predicts that half
a million financial-services jobs will go offshore to India by 2008. The employers are
hunting for skilled employees creating great opportunities for young graduates. In the
wake of a severe manpower shortage, India is witnessing the highest growth rate in
the salaries in the world! According to the 2006 Salary Guide issued by Kelly Services
India, the country has the highest average salary increase at 13.9 %. Wage rises in
Hong Kong are forecast at 1.5%, while those in Japan, Taiwan, South Korea and
Malaysia are likely to be between 2% and 3.5%.Indeed, an acute manpower shortage
especially in the finance and analytics sector has resulted in a peculiar situation of
unrelated sectors competing with one another.

For example, software giant Infosys chief Nandan Nilekani recently said the IT
industry is facing tough recruitment competition from the financial services sector.
Nilekani said that the two sectors are driving up the demand for entry-level people,
though IT continues to hire the largest number of new employees. "With the
industries competing for the best talent, financial services could offer a slightly higher
wage to grab them,'' Nilekani said.This can be related to the major hike in the salary
packages at B-Schools in the last couple of years. More dramatic demand
consequences can be seen at the campuses of Economics schools around the country,
that produce specialists aptly suited for the lucrative Finance Sector. The average
salary packages at Economics schools like Delhi School of Economics & Indian
Statistical Institute have increased by 100% in the last 5 years.