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A REPORT ON
NON-
PERFORMING
ASSETS-
CHALLENGE TO THE
PUBLIC SECTOR BANKS
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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.
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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.
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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 thatbanks 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 thebanks. 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.
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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.
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2. Research methodology
The research methodology means the way in which we would complete ourprospected 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.
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(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.
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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.
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INDIAN BANKING SECTOR
Banking in India has its origin as early as the Vedic period. It is believed that thetransition 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 19th
centurythe 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 27th
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 15thApril 1980 six more commercial private sector banks were also
taken over by the government.
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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.
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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 moreoperational flexibil ityto
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 abolishedand 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 thecompeti tive effi ciencyof banks
are the following:
Opening up the banking sector for the private sector participation.
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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 conducivelegal
environmentfor 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 ther egulatory f rameworkfor 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.
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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 createan 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 provisioningagainst 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 buildingdesirable
capitalover and above the minimum CRAR which is insisted upon in developedregulatory 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 transitionalroute 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
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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, seemto 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 from0.54 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 haverecorded 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, theresponse 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
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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 corporategovernance 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.
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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
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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 developmentof 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 followingsections.
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 exceptionof 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.
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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 therecommendations 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 rateand 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 of
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funds, 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 normsfor 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 environmenthas 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
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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 hadsought 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 financialsystem, 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).
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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 thelast 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 rangeof 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.
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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 potentiallosscredit, 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.
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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 ofassets) 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 weretherefore 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
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Intermediation cost is a significant factor explaining the differences in NIMs
across countries. Interest margins tend to be higher in countries where the intermediation
costs are high. Generally, the absence of a vibrant capital market results in the
intermediation costs being higher. In India, the debt market is relatively less developed
(as compared with the markets in USA and Europe), and therefore, most corporateentities are dependent mainly on banks for meeting their financing needs. As a result,
Indian banks are able to command higher NIMs as compared with the global benchmarks
banks. To make a like-to-like comparison and understand the impact of intermediation
cost, ICRA has compared the NIMs of the Indian operations of the global benchmark
banks with those of Indian banks. Of the six global benchmark banks, the local operations
of four banks earned higher NIMs vis-a-vis the median of Indian banks in FY2002 and
FY2003. Of these four banks, three earned NIMs above 4%. This analysis strengthens
ICRA's hypothesis that the external operating environment is an important factor while
benchmarking NIMs.
(b) Type & Quality of Assets
The higher NIMs of US-based banks are attributable to their sharper focus on
consumer loans and credit cards as compared with European banks. Also, the high NIMs
of US banks are the cause for their comparatively high ROAs. To overcome the potential
for higher provisions arising from its strategy of lending to riskier assets, a bank may
charge a higher rate of interest to its borrowers (with a consequently higher NIM) than
another bank. So while comparing the NIMs of two banks, the effect of asset quality mustbe normalised. One way of doing this is to use Total Risk Weighted Adjusts (RWA)
instead of Total Assets as the denominator. However, many Indian banks do not disclose
their RWA values in their annual reports, and therefore, ICRA has not been able to use
this method in this study. The alternative method is to adjust the NIM for provisions &
contingencies. If the asset quality of a bank is relatively weak, it is likely to generate
higher Non-Performing Assets (NPAs). As a result, its provisions & contingencies are
also likely to be higher. Therefore, if the effect of asset quality is normalised by removing
provisions & contingencies from the NIM, a better understanding of the efficiency of the
fund based business of banks may be obtained. ICRA defined adjusted NIM as NetInterest Spread (Net Interest Income less Provisions & Contingencies)/Average Total
Assets]. The Net Interest Spread's for the global benchmark banks ranged from 0.14 to
2.10% for the financial year ended December 2002, with the median at 1.54%. The
corresponding median figure for Indian banks was 1.68%. The difference between the
NIMs of the global benchmark banks and Indian bank; reduces substantially after
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adjusting for provisions. This strengthens ICRA's hypothesis that the type and quality of
assets substantially affect NIM.
(3)Accounting Policies
The Net Interest Spreads adjusted for Provisions can vary substantially,
depending on the income recognition and provisioning norms. According to International
Accounting Standard, (IAS) provisioning for NPAs is based on management discretion,
Whereas in India, the RBI defines the provisioning requirement for impaired assets as a
function of time and security. An illustration of difference in accounting for NPA is that for
Indian banks, an asset is reckoned as NPA when principal or interest are past due for 180
days as compared with 90 days for the global benchmark banks (the norms will converge
with effect from financial year 2004). Keeping in view the levels of NIM for Indian andglobal benchmark banks, and the three factors analysed above, ICRA believes that the
NIM for Indian banks is comparable with that of the global benchmark banks.
Non-Interest Income Ratio
Increased competition in the Indian Banking industry has driven the interest
yields and consequently, the NIMs, southwards. Hence, banks are increasingly
concentrating on non-interest income to shore up profits. In FY2003, the range of non-
interest income for Indian banks (as percentage of average Total Assets) was between1.01 and 3.00%. The median for Indian banks showed a moderate increase from 1.63% in
2002 to 1.77% in 2003. The non-interest income (as percentage of Average Total assets)
of the global benchmark banks varied from 0.72 to 3.13% (with a median value of
1.62%), or the year ended December 31, 2002. The decline in interest rates in India over
the last few years has helped Indian banks book substantial profits from the sale of
investments, thus boosting their Non-Interest Income. As the high profits accruing from
the sale of investments are not lively to be sustainable, ICRA has benchmarked the pure
fee based income (i.e. looking at Non-interest income without profits from sale of
investments) as a percentage of average total income. 16 of the 21 Indian banks in the
study had a fee based income ratio of between 0.4 and 0.8%.A comparison after similar
adjustment for the global benchmark banks reveals that the fee-based income ratio of
Indian banks is lower.
Operating Expense Ratio
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The Operating Expense Ratio (operating expenses as a ratio of the average total
assets) reveals how expensive it is for a bank to maintain its fixed assets and human
capital that are used to generate that income streams, The median Operating Expense
ratio for Indian banks was 2.26% in 2003, which is comparable with that for the globalbenchmark banks (2.09%).
1.7 Asset Quality Benchmarking
Gross NPAs
The median Gross NIA ratio (Gross NPA as a proportion of total advances) for
Indian banks was 9.40% for FY2003 and 10.66% for FY2002. The values of the Gross
NPA ratio for FY 2003 range between 2.26 and 14.68%.Many global banks do not
disclose their Gross NPA percentages in their annual reports.
Net NPAs
The median Net NPA ratio ("Net NPA as a proportion of Net advances) of Indian
banks was 4.33% for FY2003 and 5.39% for FY2002. The values of Net NPA ratio for
FY 2003 for the global benchmark banks ranged between 0.37 and 7.08%. Most of the
global benchmark banks do not disclose their Net NPA ratios in their annual reports.
From the study it can be inferred that the median Net NPA percentage for Indian banks is
marginally higher than that for the global benchmark banks.
Efficiency Benchmarking
ICRA studied the following parameters to assess the efficiency of Indian banks
vis--vis their foreign counterparts:
Profitability per employee
Profitability per branch
Business per employee
Business per branch
Expenses per employee
Expenses per branch
The business model of the global benchmark banks involves outsourcing of non-
core activities. In the case of Indian banks, particularly those in the public sector, both
non-core and core business functions are carried out in-house. The global benchmark
banks display higher efficiency parameters, mainly because of the outsourcing model.
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Thus, the efficiency parameters are not strictly comparable, as they are affected by the
business plans of specific banks and also by economy-specific considerations.
ICRA has presented the analysis of the performance of Indian and international banks
in the following sections. We would like to highlight that several factors influence theresults here, and caution needs to be exercised in arriving at inferences. E.g. comparing
expenses per branch (or employee) for banks across different economies involves
conversion of amounts to a common currency. The results depend on the conversion rates
of foreign exchange used (e.g. USD per rupee or Euro per rupee). In this report, ICRA
has used nominal rates of foreign currencies rather than rates based on PPP (Purchasing
Power Parity). On another dimension, Indian banks and international banks operate under
different business models and levels of technology. Increasingly, sophisticated banks
(particularly in advanced countries) use several channels to transact business with
customers, such as, the Internet, telephone, debit cards, and ATMs. Therefore, resultsfrom benchmarking using parameters such as business per branch or expenses per branch
(which are appropriate parameters to compare across banks that operate predominantly
through branches) need to be appropriately interpreted in an exercise when we compare
heterogeneous banks across different economies.
Profitability per Employee
The profit per employee figure for 17 out of the 21 Indian banks was in the range
of Rs. 0.02 crore for the financial year ended March 2003. Most Indian banks posted
higher profits per employee in FY2003 as compared with FY2002. This overall trend ofincreasing employee profitability may be attributed to the reduction in the number of
employees following the launch of Voluntary Retirement Schemes (VRS) by some banks
as well as higher profits by the banks. On an average, new private sector banks enjoy a
higher increase in profitability per employee, as compared with their public sector
counterparts. This may be attributed largely to the better technology that the new private
sector banks employ, besides the advantage of carrying no historical baggage. As for the
global benchmark banks, the profitability per employee for HSBC was robust at USD
0.12 million (Rs. 0.552 crore) for FY 2002. For ABN AMRO Bank, the figure was EUR
0.02 million (Rs.l crore). On an intertemporal basis, the profitability per employee for the
global benchmark bank also showed growth.
Profitability per Branch
For most Indian banks, the profit, per branch was in the range of Rs. 0-0.2 crore.
However, the new private sector banks displayed the highest profits per branch, at Rs.
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1.73 and 1.22 crore for the years 2003 and 2002, respectively. On an inter-temporal basis,
profit per branch has been increasing gradually in the Indian banking sector. The growth
in profit per branch for Indian banks is attributable to the overall increase in profitability
in the banking industry. In the case of the foreign peer group, profitability per branch
shows a small increase over the period covered by this study. As for the globalbenchmark banks, profitability per branch for Bank of America is at a robust USD 1.62
million (Rs. 7.44 crore), while the figure for ABN AMRO Bank is EUR 0.87 million (Rs.
4.36 crore) for the FY 2002. Hence, profitability per branch for the global benchmark
banks is higher than that of Indian banks.
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Business per Employee
Since different employees in a bank contribute in different ways to the revenues
and profits of a bank, it is difficult to come up with one universal metric that captures the
business per employee accurately. For' this analysis, ICRA has used the amount ofdeposits mobilised per employee as a measure of the business per employee. The Indian
banking industry on an average mobilised Rs. 1-2 crore of deposits per employee for the
year ended March 2003. In this respect, private sector banks lead the group of Indian
banks. The top bank in this category showed a deposit per employee of Rs. 7.14 crore for
the year ended March 2003. As for the global benchmark banks, business per employee
for HSBC was robust at USD9.71 million (Rs. 44.66 crore), while that for ABN AMRO
Bank was EUR 4 million (Rs. 20 crore) for the year ending December 2002.
Thus, deposit mobilisation per employee for the global benchmark banks is higher
than that of Indian banks.
Business per Branch
On an average, the banks showed a deposit of around Rs. 10-30 crore per branch
for the year ended March 2003. In recent times, the deposit mobilisation for Indian Banks
on a branch basis has witnessed a steady increase. The new private sector banks in India
have led the way in this regard, because of the better use of technology. The highest
deposit per branch stood at Rs. 103.24 crore in 2003 for a new private sector bank, as
compared with Rs, 68.71 crore in 2002. The global benchmark banks mobilised more
business per branch as compared with their Indian counterparts. Bank of Americamobilised USD 88.9 million (Rs. 408.94 crores) for the financial year ended 2002, while
ABN AMRO Bank mobilised EUR 140 million (Rs. 700 crores). The higher per-bank
deposit mobilisation for the global benchmark banks may be attributed to their superior
technology orientation and the higher gross domestic products (GDP) of their respective
countries. 3.5.5 Expenses per Employee
For this analysis, ICRA has used the employee expenses per employee as a
measure of the expenses per employee. Indian banks, on an average, expensed Rs. 0.025
crore per employee in FY2002. For the new private sector banks, this figure was higher.
The highest expense per employee incurred by an Indian bank for the year 2002 was Rs.
0.041 crore per employee.
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In the case of the global benchmark banks, the expenses per employee for Citi Group
Inc. was at USD 0.08 million (Rs. 0.36 crore), while for ABN AMRO Bank it was EUR
0.07 million Rs. 0.36 crore).
Expenses per Branch
For this analysis, ICRA has used operating expenses per branch as a measure of
the expenses per branch. The expense per branch for most Indian banks was Rs. 0.56
crore for FY2002. Over the years, Indian banks have reported a gradual increase in such
expenses, with competition-prompted upgrade being the primary reason for the same. In
the case of the global benchmark banks, expense per branch for Bank of America was
USD 4.93 million (amount in Rs. 22.68 crore), while for ABN AMRO Bank it was EUR
4.6 million (Rs. 22.99 crore).
1.8 Structural Benchmarking
Since its inception in 1980s) BIS has issued several guidance notes for banks and
bank supervisors. These notes have sought to improve the integrity of the global banking
system and propagate best practices in banking across the world. For issues related to
accounting, BIS has relied on the International Accounting Standards (IAS) issued by the
International Accounting Standards Committee (IASC). Banks are supposed to follow
these accounting standards as part of best practices. For the structural benchmarking
study of the Indian banking sector, ICRA has used primarily the guidance notes issued by
BIS and the relevant IAS as the benchmarks of best practices. ICRA has also referred tostandards as mentioned under, US and UK. GAAP (Generally Accepted Accounting
Practices) where they provide a good understanding of international best practices.
Capital Adequacy Norms for Banks
BIS introduced capital adequacy norms for banks for the first time in 1988. To
improve on the existing norms, BIS issued a Consultative Document in January 2001,
proposing changes to the existing framework. The objective of this document is to
develop a consensus on the Basel II Accord (as it is popularly known), which is expected
to be implemented in 2007. Based on feedback received from various quarters, BIS
issued a new Consultative Document in April 2003. In this document, BIS has proposed
the following key changes over the existing norms:
Introduction (of finer grades of risk weighting in corporate credit:
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According to the original 1988 Accord, all credit risks have a 100% per cent
weighting. Under the new method, grades of weightings in the 20-150% range will be
assigned.
Introduction of charges for operational risks:
Under the proposed Basel II Accord, banks have to allocate capital for operational
risks. BIS has suggested three methods for estimating operational risk capitals:
1. Basic Approach,
2. Standardised Approach, and
3. Advanced Measurement Approach.
Capital requirement for mortgages reduced:
The risk weights on residential mortgages will be reduced to 35% from 50%.
During the 1990s, the RBI adopted the strategy of attaining a Capital Adequacy Ratio(CAR) of 8% in a phased manner. Subsequently, in line with the recommendations of the
Committee on Banking Sector Reforms, the minimum CAR was further raised to 9%,
effective 31st March 2000.
As a step towards implementing the Basel II guidelines, the RBI in its circular of
14th May, 2003 has proposed new methods for estimating regulatory risk capital. To
estimate the impact of the proposed changes on the capital adequacy position of Indian
banks, the RBI has asked select banks to estimate their riskweighted assets on the basis of
the new method. As per this, the RBI has asked for the estimation of capital requirementon the basis of the external credit rating of borrowers. For nonrated borrowers, the RBI
has asked the select banks to use the existing 100% risk weights.
The RBI has also asked the banks to calculate operational risk capital separately
following the Basel approach. Based on the result of the exercise, the RBI will issue new
guidelines on estimating economic capital.
Additionally, the RBI has asked banks to introduce internal risk scoring models. It is
expected that once the Basel II Accord is signed, the RBI will allow banks to move to the
IRB approach.
The Capital Adequacy norms in India are in line with the best practices as suggested
by BIS. Once the Basel II Accord is implemented, the method of estimation of risk
capital will undergo a significant change. RBI has already taken appropriate steps to
prepare the Indian banking industry for such changes.
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Recognition of Financial Assets & Liabilities
IAS 39 requires that all financial assets and all financial liabilities be recognised
on the balance sheet. This includes all derivatives. Historically, in many parts of the
world, derivatives have not been recognised as liabilities or assets on balance sheets. The
argument for this practice has been that at the time the derivative contract was enteredinto, no cash or other asset was paid. The zero cost justified non-recognition,
notwithstanding the fact that as time pauses and the value of the underlying variable (rate,
price, or index) changes, the derivative has a positive (asset) or negative (liability) value.
In India, derivatives are still off-balance sheet items and considered part of
contingent liabilities. So in Indian treatment of derivatives is different from International
Accounting Standards.
Valuation of Financial Assets
IAS 39 has classified financial assets under four categories. The following table
summarises the classification and measurement scheme for financial assets under IAS 39,
Under US GAAP, marketable equity securities and debt securities are classified as under:
trading,
Available for sale, or held
to maturity.
Recognition of Non-Performing Assets (NPAs)/Impaired Assets
Under IAS 39, impairment recognition is left to management discretion (itsperception of the likelihood of recovery). Impairment calculation compares the carrying
amount of the financial asset with the present value of the currently estimated amounts
and timings of payments. If the present value is lower than. The carrying amount, the loan
is classified as NPL.
Under US GAAP, loans assume non-accrual statuses if any of the following conditions
are fulfilled:
Full repayment of principal or interest is in doubt (in management's judgment), or
if scheduled principal or interest payment is past due 90 days or more, and if the
collateral is insufficient to cover the principal and interest.
In India, NPAs are classified under three categories-Sub-standard, Doubtful and
Loss on the basis of the number of months the amount is overdue for. India proposed to
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move from 180 days to a 90-day past due classification rule for NPA recognition
effective March 2004.
The financial instrument's original effective interest rate is the rate to be used for
discounting. Any impairment loss is charged to profit and loss account for the period.Impairment or "uncollectability" must be evaluated individually for material financial
assets. A portfolio approach may be used for items that are individually small [IAS
39.109]. Therefore, under IAS, provisioning is based on management discretion.
Provision in excess of expected loan losses may be booked directly to shareholders'
equity. As with IAS, under the UK, And US GAAP also, provisioning is based on
management discretion. Under US GAAP, when the Net Present Value of a loan is less
than the carrying value, the difference is booked as provision.
In India; provisioning norms are more explicit than they are under the IAS. RBIhas specified norms for various classes of NPL as follows:
Standard Assets: 10%
Doubtful Assets: 100% of unsecured portion,
20-50% on secured portion
Loss Assets: 100%
Interest Accrual on M on-performing Loans / impaired Assets
Under both IAS and US GAAP, there is no specific prescription for interestaccrual on NPAs. Under UK. GAAP, interest is suspended upon classification as NPL.
However, suspension may be deferred up to 12 months if sufficient collateral exists.
According to Sound Practices for Loan Accounting and Disclosure (1999) number
11, the BIS Committee on Banking Supervision recommends that when a loan is
identified as impaired, a bank should cease accruing interest in accordance with the terms
of the contract. Interest on impaired loans should not contribute to net income if doubts
exist over the collectability of loan interest or principal.
In India, accrual of interest is suspended upon classification of a loan as non
performing.
General Provisioning on Performing Loans
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Under IAS, UK and US GAAP, there is no specific prescription for general
provisioning towards performing loans. However, Indian banks have a provisioning
require; f tent of 0.2 5% on all standard assets.
Conclusion
The RBI norms for classification of assets, and provisioning against, bad/doubtful
debts are more detailed and precise vis-a-vis international rules. While the international
norms often leave bad debt provision levels to "management discretion", Indian standards
are precise and clearly state exactly when and by how much reported earnings must be
charged off for bad debts.
In India, detailed accounting standards for derivatives are yet to be introduced. As of
now, derivatives continue to be considered as off-balance sheet liabilities.
1.9 Likely Future Trends and their Implications for Indian Banks
Financial Disintermediation and Bank Profitability
The degree of banking disintermediation and financial sophistication are
important factors in the development of a country's economy. Disintermediation affects
the allocation process for both savings and credits in the economy. With the introduction
of sophisticated deposit products by mutual funds, pension funds and insurance
companies, individual and corporate depositors now have more options for savings. A
similar trend is also visible in credit offerings. More and more corporate entities are now
approaching the capital market to raise funds either in the form of debt or equity.At the end of the 1990s, the US banking industry was facing a high level of
disintermediation, as most outstanding savings were in mutual funds, pension funds, and
life insurance plans, but not in bank deposits or other liability products. However, in
continental Europe, most banking systems (as in Germany, Spain, Italy, Austria, France,
etc.) are still highly bank-intermediated, although the trend is clearly towards faster
disintermediation for both savings and credits. In India, financial disintermediation is
likely to catch up with banks sooner than later. With the opening up of the financial
sector, Indian banks are facing competition from the mutual fund and insurance sectors
for savings. On the credit side, good quality borrowers have started raising debt directly
from the market at competitive rates.
Changing Capital Adequacy Norms
Capital adequacy norms for banks are likely to undergo a change after the Basel II
Accord is implemented. In the current system, Indian banks need to allocate 9% capital,
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irrespective of the credit quality of a borrower. In the new system, a bank offering credit
to a better quality corporate entity is likely to require less regulatory capital. The
allocation of regulatory capital on the basis of credit quality would encourage banks to
estimate their Risk adjusted Return on Capital (RAROC) rather than compute simple
margins. Similarly, banks now need to distinguish between the credit qualities ofsovereign borrowings and inter-bank borrowing, as they would need to allocate capital to
sovereign credit and inter-bank credit on the basis of external ratings, or using the IRB
approach.
To emerge successful in the Basel II regulatory environment, banks would need to
introduce the practice of risk-based pricing of loans, which in turn would require a bank
to implement advance Risk Management Systems. To implement such systems, banks
would need to implement the following key steps:
Develop Credit Risk Scoring Models Generate Probability of Default (PD) associated with each risk grade
Estimate Loss Given Default (LGD) for each collateral type.
Calculate expected and unexpected loss in a portfolio based on correlation
amongst loans.
Compute the capital that would be required to be held against economic loss
potential of the portfolio.
Similarly, banks would have to introduce robust systems for measuring and
controlling Market Risk and Operations Risk. .3 Management of Non-Performing
Assets The size of the NPA portfolio in the Indian banking industry is close to Rs.
1,00,000 crore, which is around 6% of India's GDP. NPAs affect banks profitability on
two counts:
The introduction of scientific credit risk management systems would lower
slippage of assets from the performing to the nonperforming category. Further, banks
with better NPA recovery processes would be able to reduce their provisioning
requirements, thereby increasing their profitability. To enable a fair borrower-lender
relationship in credit, the Government of India has recently enacted the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security interest Act 2002 (SRES
Act). Due to several cases still to be resolved in courts of law, it is. Not clear as yet, how
far this Act is set to alter the NPA recovery scenario in India.
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Following the announcement of the RBI's Asset Classification norms, the process
of Asset Quality Management involves segregating the total portfolio into three segments
and having detailed strategies for each. The three segments are:
Standard/Performing Assets
Special Mention Accounts/Sub-Standard Assets Chronic Non-Performing Assets
Banks need to vigilantly monitor Standard Assets to arrest any account slippage
into the non-performing grade. Besides, banks need to churn their credit portfolio so as to
maximise returns while keeping the risks pegged at acceptable levels.
Special Mention Accounts are assets with potential weaknesses which deserve
close attention and timely remedial action. The typical warning signs exhibited by a
borrower ranges from frequent excesses in the account to non-submission of periodicalstatements. Account restructuring and rehabilitation tools are best implemented during
this stage. However, the challenges faced while restructuring include, (a) selecting the
genre of assets to be restructured, (b) quantifying the benefits to be extended, (c)
determining repayment schedules, and (d) coordinating and balancing the needs of
several lenders.
Chronic Non-Performing Assets can now be better managed following the
enactment of the SIZES Act. The Act provides the requisite regulatory framework for the
foreclosure of assets by lenders, incorporation of Asset Reconstruction Companies
(ARCS), and formation of a Central Registry. In the wake of this new legislation,
amicable solutions may be realised for Chronic NPAs. The strategies include
Enforcement of Security Interest, Securitisalion, One-Time Settlement (OTS), and Write-
off. However, a scientific approach to deciding which of these alternative routes must be
taken hinges on: (a) assessment in terms of quality of the underlying assets and their
realisable value, (b) alternative use of the assets, and (c) willingness of the borrower to
settle outstanding dues.
conclusion
The profitability of Indian banks in recent years compares well with that of the
global benchmark banks primarily because of the higher share of profit on the sale of
investments, higher leverage and higher net interest margins of Indian banks. However,
many of these drivers of higher profits of Indian banks may not be sustainable. To ensure
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long-term profitability, Indian banks need to focus on the following parameters and build
systemic capability in management of the same:
Ensure that loans are diversified across several customer segments
Introduce robust risk scoring techniques to ensure better quality of loans,
as well as to enable better risk-adjusted returns at the portfolio level Improve the quality of credit monitoring systems so that slippage in asset
quality is minimised
Raise the share of non-fund income by increasing product offerings
wherever necessary by better use of technology
Reduce operating expenses by upgrading banking technology, and
Improve the management of market risks
Reduce the impact of operational risks by putting in place appropriate
frameworks to measure risks, mitigate them or insuring them.
The RBI as the regulator of the Indian banking industry has shown the way in
strengthening the system, and the individual banks have responded in good measure in
orienting them selves towards global best practices.
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DISTRIBUTION OF THE INDIAN BANKS AS TO STATES
AND POPULATION
How Indian banks are distributed as to states and population is explained from the
following table:
Table- Distribution of Banking Centers According to State and Population Group (As at The End of March)
POPULATION GROUP RURAL SEMI-URBAN URBAN METROPOLITAN ALL CENTRES
REGION/STATE/ 2001 2002 2001 2002 2001 2002 2001 2002 2001 2002
UNION TERRITORY 1 2 3 4 5 6 7 8 9 10
NORTHERN REGION 4578 4576 458 458 36 36 3 3 5075 5073Haryana 644 644 94 94 11 11 749 749
Himachal Pradesh 605 605 14 14 619 619 Jammu & Kashmir 477 477 2222 2 2 501 501 Punjab 1022 1023 102 102 991 11134
1135 Rajasthan 1765 1762 212 212 13 13 111991 1988Chandigarh 9922 11 12 12 Delhi 55 56 12 12 1169
69
NORTH-EASTERN REGION 1166 1152 123 123 8 8 1297 1283Arunachal Pradesh 53 53 6 6 59 59Assam 749 736 73 73 44 826 813 Manipur
40 39 11 11 11 52 51 Meghalaya122 122 77 11 130 130 Mizoram 6060 55 11 66 66 Nagaland 34 34 88
42 42 Tripura 108 108 13 13
11
122 122
EASTERN REGION 6979 6972 773 773 67 68 1 1 7820 7814Bihar 2346 2346 313 313 12 12 2671 2671Jharkhand 906 904 88 88 44 998 996 Orissa 1533
1532 93 93 66 1632 1631 Sikkim 32
32 11 33 33
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West Bengal 2147 2143 276 276 45 45 1 1 2469 2465Andaman & Nicobar Islands 15 15 2 2 17 17
CENTRAL REGION 7368 7331 805 805 60 60 4 4 8237 8200Chhattisgarh 639 629 61 61 6 6 706 696Madhya Pradesh 1698 1680 225 225 15 15 22 1940 1922 Uttar
Pradesh 4539 4530 480 480 36 36 22 5057 5048 Uttaranchal492 492 39 39 33 534 534
WESTERN REGION 3777 3767 674 674 42 42 7 7 4500 4490Goa 140 140 12 12 152 152Gujarat 1445 1438 260 260 14 14 33 1722 1715Maharashtra 2186 2183 399 399 28 28 44 2617 2614 Dadra &Nagar Haveli 5 5 1 1 6 6Daman & Diu 11 2 2 3 3
SOUTHERN REGION 6400 6359 2218 2213 83 83 3 3 8704 8658Andhra Pradesh 2283 2279 466 466 35 35 1 1 2785 2781Karnataka 2064 2057 278 278 15 15 1 1 2358 2351
Kerala 303 304 1039 1037 7 7 1349 1348Tamil Nadu 1719 1691 430 427 25 25 11 2175 2144Lakshadweep 9 9 9 9Pondicherry 22 19 5 51 1 28 25
ALL-INDIA 30268 30157 5051 5046 296 296 18 18 35633 35517
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MAJOR DEVELOPMENTS IN BANKING AND
FINANCE
Banking Developments
The RBI allowed resident Indians to maintain foreign currency accounts. The
accounts to be known as resident foreign currency (domestic) accounts, can be used to
park forex received while visiting any place abroad by way of payment for services, or
money received from any person not resident in India, or who is on a visit to India, in
settlement of any lawful obligations. These accounts will be maintained in the form of
current accounts with a cheque facility and no interest is paid on these accounts. With a
view to liberalise gold trading, the Reserve Bank has decided to permit authorised banksto enter into forward contracts with their constituents like exporters of gold products,
jewellery manufacturers and trading houses, in respect of the sale, purchase and loan
transactions in gold with them. The tenor of such contracts should not exceed 6 months.
The Reserve Bank of India has told foreign banks not to shut down branches without
informing the central bank well in advance. Foreign banks have been further advised by
the Reserve Bank of India to furnish a detailed plan of closure to ensure that their
customers' interests and conveniences are addressed properly.
The RBI has prohibited urban co-operative banks from acting as agents or sub-agents of money transfer service schemes. The RBI has allowed banks to invest
undeployed foreign currency non-resident (FCNR-B) funds in the overseas markets in the
long-term fixed income securities with ratings a notch lower than highest safety. Earlier,
banks were allowed to invest only in long-term securities with highest safety ratings by
international agencies.
The RBI has defined the term "willful defaulter" paving the way for banks to
acquire assets of defaulting companies through the Securitisation Ordinance and reduce
their NPAs faster. According to the RBI a wilful defaulter is one who has not used bank
funds for the purpose for which it was taken and who has not repaid loans despite having
adequate liquidity. International credit rating agency Standard & Poor has estimated that
the level of gross problematic assets in India can move into the 35-70 per cent range in
the event of a recession. It has also estimated that the level of non-performing assets
(NPAs) in the system to be at 25 per cent, of which only 30 per cent can be recovered.
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The Reserve Bank of India has decided to extend operation of the guidelines for
the one time settlement scheme for loans upto Rs.50,000 to small and marginal farmers
by public sector banks for another 3 months, i.e, upto March 31, 2003.
The Reserve Bank of India, as part of its policy of deregulating interest rates on
rupee export credit, has freed interest rates on the second slab - 181 to 270 days for pre-
shipment credit and 91 to 180 days for post-shipment credit with effect from May 1, 2003.
The Cabinet cleared a financial package for IDBI and agreed to take over the
contingent liabilities to the tune of Rs.2500 crore over five years. The IDBI Act will be
repealed during the winter session of the Parliament, paving the way for IDBI's
conversion into a banking company.The IDBI would be given access to retail deposits, to
enable it to bring down the cost of funds, but will be spared from priority sector lendingand SLR requirements for existing liabilities.
The RBI has issued guidelines for setting up of offshore banking units (OBUs)
within special economic zones (SEZs) in various parts of the country. Minimum
investment of $10 million is required for setting up an OBU. All commercial banks are
allowed to set up one OBU each. OBUs have to undertake wholesale banking operations
and should deal only in foreign currency. Deposits of the OBUs will not be covered by
deposit insurance. The loans and advances of OBUs would not be reckoned as net bank
credit for computing priority sector lending obligations. The OBUs will be regulated andsupervised by the exchange control department of the RBI.
With a view to develop the derivatives market in India and making available
hedged currency exposures to residents an RBI Committee headed by Smt. Grace Koshie,
recommended phased introduction of foreign currency-rupee (FC/NR) options._The
Reserve Bank of India has notified the draft scheme for merging Nedungadi Bank with
Punjab National Bank. This is the first formal step towards bringing about a merger
between the two Banks.
The Reserve Bank of India has agreed to allow capital hedging for foreign banksin India. The guidelines pertaining to capital hedging will be issued by RBI soon.
The Reserve Bank of India has decided to allow foreign institutional investors
(FIIs) to enter into a forward contract with the rupee as one of the currencies, with an
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authorised dealer (AD) in India to hedge their entire exposure in equities at a particular
point of time without any reference to the cut -off date. Further, the RBI has also
increased Authorised Dealer's overseas market investment limit to 50 per cent of their
unimpaired tier-I capital or $ 25 million, whichever is higher.
The Reserve Bank of India doubled the foreign exchange available under the
basic travel quota (BTQ) to resident individuals from US $5000 to US $10000, or its
equivalent.The Government has decided to dispose of UTI Bank as part of restructuring
Unit Trust of India.Though the details in this regard is yet to be worked out, it has been
decided that the bank will be disposed of during the course of the restructuring.
The RBI has allowed tour operators to sell tickets issued by overseas travel
operators such as Eurorail and other rail/road and water transport operators in India, in
rupees, without deducting the paymentfrom the travellers' basic travel quota.
The Reserve Bank of India (RBI) has banned banks from offering swaps
involving leveraged structures, which can cause huge losses if the market moves the other
way.
The RBI constituted committee on payment system has recommended that the
central bank, as the regulator of payment and settlement systems, should be empowered
to regulate non-banking systems.
Market Developments and New Products
The Hong Kong and Shanghai Banking Corporation will be bringing $150
million additional capital to India in the current fiscal.
The Reserve Bank of India has ordered a moratorium on the Nedungadi Bank.
The moratorium effective from the close of business will be in force upto February 1,
2003. During this period, the central bank is likely to finalise the plans for merging
Nedungadi Bank with Punjab National Bank.
ABN Amro Bank launched its Business Process outsourcing (BPO) operations,
ABN Amro Central Enterprise Services (ACES) in Mumbai. It has been set up with an
initial investment of 4 million euros (Rs.19 crore) and has been capacitised at 650 seats in a
single shift.
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The Canara Bank has returned 48 per cent (Rs. 277.87 crore) of its capital to the
Government before its Initial Public Offer.
China has granted licence to Bank of India to open a representative office in thesouth Chinese city of Shenzhen.
Shri A.K. Purwar is app