INDIAN FINANCIAL SYSTEM AN OVERVIEW

An efficient, articulate and developed financial system is indispensable for the rapid economic growth of any country/economy. The process of economic development is invariably accompanied by a corresponding and parallel growth of financial organizations. However, their institutional structure, operating policies, regulatory/legal framework differ widely, and are largely influenced by the prevailing politico-economic environment. Planned economic development in India had greatly influenced the course of financial development. The liberalization/ deregulation/ globalization of the Indian economy has had important implications for the future course of development of the financial system/sector.

Financial sector reforms were initiated as part of overall economic reforms in the country and wide ranging reforms covering industry, trade, taxation, external sector, banking and financial markets have been carried out since mid 1991. A decade of economic and financial sector reforms has strengthened the fundamentals of the Indian economy and transformed the operating environment for banks and financial institutions in the country. The sustained and gradual pace of reforms has helped avoid any crisis and has actually fuelled growth. As pointed out in the RBI Annual Report 2001-02, GDP growth in the 10 years after reforms i.e. 1992-93 to 2001-02 averaged 6.0% against 5.8% recorded during 1980-81 to 1989-90 in the pre-reform period.

INTRODUCTION TO BANKING SYSTEM

"Banking has traditionally remained a protected industry in many emerging economies. However, a combination of developments has compelled banks to change the old ways of doing business. These include, among others, technological advancements, disinter mediation pressures arising from a liberalized marketplace, increased emphasis on shareholders' value and macroeconomic pressures and banking crises in 1990s. As a consequence of these developments, the dividing line between financial products, types of financial institutions and their geographical locations have become less relevant than in the past."

Profits and profitability were indeed looked for, but this goal was preceded by greater importance to norms of security and liquidity. Speculation was considered a sin. Traditional banking services included accepting deposits from the public, lending a part of the same on short term basis, and investing another portion in gilt-edged securities, while also holding a certain percentage in cash, as balance with the Central Bank of the country, and in the call money market. Thus the definition of "Banking" as per the Banking Regulation Act, 1949 says-

Banking means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise".

The Act defined the functions that a commercial bank can undertake and restricted their sphere of activities. It prohibited banks from owning non-banking assets. No Company other than a commercial bank licensed by the RBI can include the words "Bank" or "Banking" as part of its name. Thus the boundary for banking and financial services was mutually demarcated and assigned separately between commercial banks and non-banking financial companies respectively. The one cannot encroach on the domain of the other.

The initial move away from traditional concepts of banking took place after nationalization of banks in 1969/70. Banks started lending on medium Term basis repayable between 3 to 7 years. After Nationalization banks also diversified credit extension comprehensively to cater different sectors of the economy. Term Lending, lending extensively against hypothecation of securities, financing qualified and technical entrepreneurs, financing craftsmen and artisans, financing purchase of consumer durable, financing acquisition & constructions of houses, office premises, vehicles, financing agriculture & allied activities, small-scale industries and exports etc. came into vogue. It was still a mere diversification of credit-delivery functions, and a transition from commercial banking to development banking looking towards social objectives of employment generation and poverty alleviation under Government ownership covering the major segment of Indian Banking

Since the beginning of the Eighties, the International Financial Markets are witnessing revolutionary structural changes in terms of financial instruments and the nature of lenders and borrowers. On the one hand there is a declining role for the Banks in direct financial intermediation. On the other hand there is enormous increase in securitised lending, the growth of new financial facilities of raising funds directly from investors. There is also the growth of innovative techniques such as interest rate swaps, financial and foreign exchange futures and foreign exchange and interest rate options.

International Finance has to deal with and cater to the complex financial needs relating to the global economic activities. It has to satisfy to diverse customers like individuals, commercial organizations and government owned corporations spread over various countries. By nature these requirements could not be uniform. A stream of financial products has therefore come into usage to meet specific needs of both investors and borrowers. The range of product covers fund raising, underwriting, hedging or arbitrage instruments. The dynamism, in terms of variety and packages provided, as exhibited by the International Financial & Banking market has led to the equating of Euro-banking operations, the nerve center of global financial and banking services as "financial engineering".

"The institution of banks continues to have a unique place within the financial system. This is due to their 'franchise' i.e., their unique ability to issue monetary liabilities by leveraging non-collateralized deposits. Over the last three decades, however, the role of banking in the process of financial intermediation has been undergoing a profound transformation, owing to changes in the global financial system. It is now clear that a thriving and vibrant banking system requires a well-developed financial structure with multiple intermediaries operating in markets with different risk profiles.

Firstly, the proliferation of financial innovations has led to a blurring of the boundaries between traditional banking and other types of financial intermediation. Today, banks operate with a wide variety of financial assets and liabilities, some of which are created by the non-bank constituents of the financial system. Secondly, specialized markets have come into being for each class of financial instruments and banks have to transact business in various segments of the financial market spectrum in the process of their routine day-to-day business. Thirdly, banks undertake leveraging transformations as part of their intermediation - asset-liability, debt-equity, collateralized/ non-collateralized, maturity, size and risk. This necessarily involves other types of financial intermediaries as counter parties, in syndications and co-financing strategies, as also in the sharing of risk. Fourthly, active global capital movements and the growing volume of cross-border trade in financial services have exerted external pressures for reorientation and refocusing of activities for all players in financial markets.

"Since the early 1990s, banking systems worldwide have been going through a rapid transformation. Mergers, amalgamations and acquisitions have been undertaken on a large scale in order to gain size and to focus more sharply on competitive strengths. This consolidation has produced financial conglomerates that are expected to maximize economies of scale and scope by 'bundling' the production of financial services. The general trend has been towards downstream universal banking where banks have undertaken traditionally non-banking activities such as investment banking, insurance, mortgage financing, securitisation, and particularly, insurance. Upstream linkages, where non-banks undertake banking business, are also on the increase. The global experience can be segregated into broadly three models. There is the Swedish or Hong Kong type model in which the banking corporate engages in in-house activities associated with banking. In Germany and the UK, certain types of activities are required to be carried out by separate subsidiaries. In the US type model, there is a holding company structure and separately capitalized subsidiaries.

In India, the first impulses for a more diversified financial intermediation were witnessed in the 1980s and 1990s when banks were allowed to undertake leasing, investment banking, mutual funds, factoring, hire-purchase activities through separate subsidiaries. By the mid-1990s, all restrictions on project financing were removed and banks were allowed to undertake several activities in-house. In the recent period, the focus is on Development Financial Institutions (DFIs), which have been allowed to set up banking subsidiaries and to enter the insurance business along with banks. DFIs were also allowed to undertake working capital financing and to raise short-term funds within limits. It was the Narasimham Committee II Report (1998), which suggested that the DFIs should convert themselves into banks or non-bank financial companies, and this conversion was endorsed by the Khan Working Group (1998). The Reserve Bank's Discussion Paper (1999) and the feedback thereon indicated the desirability of universal banking from the point of view of efficiency of resource use, but it also emphasized the need to take into account factors such as the status of reforms, the state of preparedness of the institutions, and a viable transition path while moving in the desired direction."

The strategy of banking development during the period 1969- 1992, following nationalization of major banks, first in 1969 and later in 1980, paid rich dividends to the Indian economy. This was demonstrated in the expansion of the banking network, as well as, various indicators reflecting financial deepening and widening. Nevertheless, from the vantage point of 2003, it seems that there were a number of costs associated with this strategy.

Two major costs were:

(a) Sacrifice of the efficiency gains in banking (in terms of lack of improvement of productivity), and

(b) Large pre-emption of lendable resources of the banks.

Besides, the instruments of social control, in the form of credit controls and concessional lending, had the effect of segmenting financial markets, blunting the process of price discovery and undermining the efficiency of resource allocation.

Banking sector reforms, launched ten years ago in 1992-93, were a key constituent in the wider macroeconomic strategy of financial liberalization. The 1990s took the process of institution building to its logical conclusion by creating an environment in which these institutions could function effectively. The challenge before the Reserve Bank was, thus, to rejuvenate the process of price discovery, without either sacrificing the social imperatives of a developing economy or compromising financial stability.

Banking sector reforms involved a three-pronged macro-economic strategy of dismantling the regime of administered interest rates, introducing financial instruments and making financial markets capable of allocating resources in line with market signals, and at the same time, ensuring credit delivery for the relatively disadvantaged sections of society. This was reinforced by a series of micro-economic measures to introduce more private sector players (domestic and foreign) to infuse competition and accord freedom of portfolio allocation across markets, especially centering around withdrawal of balance sheet restrictions in the form of statutory pre emption, such as, the cash reserve ratio (CRR) and statutory liquidity ratio (SLR). Besides, an incentive structure had to be put in place to channel funds to areas of social concern in tune with the spirit of financial liberalization and the imperatives of poverty eradication. A new development is the experiment of micro-finance, through self-help groups either funded by banks directly or through intermediaries. Finally, there was the need to harness the developments in information technology to improve the functional efficiency of the banking system.

The Reserve Bank now accords banks substantial freedom in determining their portfolios as well pricing their products, except in specific cases such as interest rates chargeable on small loans and priority sector advances. The Reserve Bank has instituted a number of measures to ensure the healthy functioning of the banking system including prudential norms pertaining to capital adequacy, income recognition and asset classification backed by strict provisioning norms. This is being supplemented by the institution of asset- liability management and risk management systems in line with the best international practices. In view of the growing complexities of the economy, the Reserve Bank has supplemented the micro- on-site supervision system with a macro-based supervisory strategy based on off-site monitoring and control systems internal to the banks, on the lines of CAMELS (Capital Adequacy, Management, Liquidity and Systems).

In the realm of carefully sequenced banking sector reforms, India has a lot to cheer about. The improvement in the profitability of the banking system in the recent years has been accompanied by an enhancement in asset quality. There is, however, no room for complacency, and all the stake holders in the banking sector have to strive hard. As far as the Reserve Bank is concerned, we have come a long way from micro monitoring to macro-supervision of the banking sector. Recent initiatives, such as, risk-based and consolidated supervision, adoption of various international standards and codes, as well as, moving closer towards Basel II are all symptomatic of the Reserve Banks commitment towards building a robust and vibrant banking sector. The key challenge in the future is to build in appropriate risk management practices to consolidate the gains of the past and fully exploit the opportunities while managing the threats emanating from increasing financial globalization and integration.

The most significant achievement of the financial sector reforms has been the marked improvement in the financial health of commercial banks in terms of capital adequacy, profitability and asset quality as also greater attention to risk management. Further, deregulation has opened up new opportunities for banks to increase revenues by diversifying into investment banking, insurance, credit cards, depository services, mortgage financing, securitization, etc. At the same time, liberalization has brought greater competition among banks, both domestic and foreign, as well as competition from mutual funds, NBFCs, post office, etc. Post-WTO, competition will only get intensified, as large global players emerge on the scene. Increasing competition is squeezing profitability and forcing banks to work efficiently on shrinking spreads. Positive fallout of competition is the greater choice available to consumers, and the increased level of sophistication and technology in banks. As banks benchmark themselves against global standards, there has been a marked increase in disclosures and transparency in bank balance sheets as also greater focus on corporate governance.

Major Reform Initiatives

Some of the major reform initiatives in the last decade that have changed the face of the Indian banking and financial sector are:

Interest rate deregulation: Interest rates on deposits and lending have been deregulated with banks enjoying greater freedom to determine their rates.

Adoption of prudential norms in terms of capital adequacy, asset classification, income recognition, provisioning, exposure limits, investment fluctuation reserve, etc.

Reduction in pre-emption: lowering of reserve requirements (SLR and CRR), thus releasing more lendable resources which banks can deploy profitably for streamlining the working of the credit process of the bank;

Government equity in banks has been reduced and strong banks have been allowed to access the capital market for raising additional capital.

Banks now enjoy greater operational freedom in terms of opening and swapping of branches, and banks with a good track record of profitability have greater flexibility in recruitment.

New private sector banks have been set up and foreign banks permitted to expand their operations in India including through subsidiaries. Banks have also been allowed to set up Offshore Banking Units in Special Economic Zones.

New areas have been opened up for bank financing: insurance, credit cards, infrastructure financing, leasing, gold banking, besides of course investment banking, asset management, factoring, etc.

New instruments have been introduced for greater flexibility and better risk management: e.g. interest rate swaps, forward rate agreements, cross currency forward contracts, forward cover to hedge inflows under foreign direct investment, liquidity adjustment facility for meeting day-to-day liquidity mismatch.

Several new institutions have been set up including the National Securities Depositories Ltd., Central Depositories Services Ltd., Clearing Corporation of India Ltd., Credit Information Bureau India Ltd.

Limits for investment in overseas markets by banks, mutual funds and corporate have been liberalized. The overseas investment limit for corporate has been raised to 100% of net worth and the ceiling of $100 million on prepayment of external commercial borrowings has been removed. MFs and corporate can now undertake FRAs with banks. Indians allowed to maintain resident foreign currency (domestic) accounts. Full convertibility for deposit schemes of NRIs introduced.

Universal Banking has been introduced. With banks permitted to diversify into long-term finance and DFIs into working capital, guidelines have been put in place for the evolution of universal banks in an orderly fashion.

Technology infrastructure for the payments and settlement system in the country has been strengthened with electronic funds transfer, Centralised Funds Management System, Structured Financial Messaging Solution, Negotiated Dealing System and move towards Real Time Gross Settlement.

Adoption of global standards: Prudential norms for capital adequacy, asset classification, income recognition and provisioning are now close to global standards. RBI has introduced Risk Based Supervision of banks (against the traditional transaction based approach). Best international practices in accounting systems, corporate governance, payment and settlement systems, etc. are being adopted.

Credit delivery mechanism has been reinforced to increase the flow of credit to priority sectors through focus on micro credit and Self Help Groups. The definition of priority sector has been widened to include food processing and cold storage, software upto Rs. 1 crore, housing above Rs. 10 lakh, selected lending through NBFCs, etc.

RBI guidelines have been issued for putting in place risk management systems in banks. Risk Management Committees in banks address credit risk, market risk and operational risk. Banks have specialised committees to measure and monitor various risks and have been upgrading their risk management skills and systems.

The limit for foreign direct investment in private banks has been increased from 49% to 74% and the 10% cap on voting rights has been removed. In addition, the limit for foreign institutional investment in private banks is 49%.

THE CONCEPT OF UNIVERSAL BANKINGThe entry of banks into the realm of financial services was followed very soon after the introduction of liberalization in the economy. Since the early 1990s structural changes of profound magnitude have been witnessed in global banking systems. Large scale mergers, amalgamations and acquisitions between the banks and financial institutions resulted in the growth in size and competitive strengths of the merged entities. Thus, emerged new financial conglomerates that could maximize economies of scale and scope by building the production of financial services organization called Universal Banking.

By the mid-1990s, all the restrictions on project financing were removed and banks were allowed to undertake several in-house activities. Reforms in the insurance sector in the late 1990s, and opening up of this field to private and foreign players also resulted in permitting banks to undertake the sale of insurance products. At present, only an 'arm's length relationship between a bank and an insurance entity has been allowed by the regulatory authority, i.e. IRDA (Insurance Regulatory and Development Authority).

The phenomenon of Universal Banking as a distinct concept, as different from Narrow Banking came to the forefront in the Indian context with the Narsimham Committee (1998) and later the Khan Committee (1998) reports recommending consolidation of the banking industry through mergers and integration of financial activities.

Definition of Universal Banking: As per the World Bank, "In Universal Banking, large banks operate extensive network of branches, provide many different services, hold several claims on firms(including equity and debt) and participate directly in the Corporate Governance of firms that rely on the banks for funding or as insurance underwriters".

According to Saunders, Anthony. A and Walter Ingo, 1994 Universal banking is defined as the conduct of range of financial services comprising deposit taking and lending, trading of financial instruments and foreign exchange (and their derivatives) underwriting of new debt and equity issues, brokerage investment management and insurance.

Universal banking helps service provider to build up long-term relationships with clients by catering to their different needs. The client also benefits as he gets a whole range of services at lower cost and under one roof.In a nutshell, a Universal Banking is a superstore for financial products under one roof. Corporate can get loans and avail of other handy services, while can deposit and borrow. It includes not only services related to savings and loans but also investments.

However in practice the term 'universal banking' refers to those banks that offer a wide range of financial services, beyond the commercial banking functions like Mutual Funds, Merchant Banking, Factoring, Credit Cards, Retail loans, Housing Finance, Auto loans, Investment banking, Insurance etc. Universal Banking is a multi-purpose and multi-functional financial supermarket (a company offering a wide range of financial services e.g. stock, insurance and real-estate brokerage) providing both banking and financial services through a single window.

This is most common in European countries.For example, in Germany commercial banks accept time deposits, lend money, underwrite corporate stocks, and act as investment advisors to large corporations. In Germany, there has never been any separation between commercial banks and investment banks, as there is in the United States.

Universal banking is a combination of commercial banking, investment banking and various other activities, including insurance. It seeks to provide the entire gamut of financial products under one roof and reflects the global convergence between commercial banks, investment banking and insurance companies. The convergence is an attempt by banks to fulfill the lifelong needs of the customer by following the cradle-to-grave concept. Commercial banks have a long-term relationship with their customers when compared to other financial intermediaries.

To put in simple words, a universal bank is a superstore for financial products. Under one roof, corporate can get loans and avail of other handy services, while individuals can bank and borrow. To convert itself into a universal bank, an entity has to negotiate several regulatory requirements. Therefore, universal banks in a nutshell have been in the form of a group-concerns offering a variety of financial services like deposits, short term and long term loans, insurance, investment banking etc, under an umbrella brand. Citicorp is a reasonably good example of a global UB. JB Morgan is another. The concept has been prevalent in developed countries like France, Germany and US.

Universal Banking, means the financial entities the commercial banks, Financial Institutions, NBFCs, - undertake multiple financial activities under one roof, thereby creating a financial supermarket. The entities focus on leveraging their large branch network and offer

wide range of services under single brand name. The term universal banks in general refers to the combination of commercial banking and investment banking, i.e., issuing, underwriting, investing and trading in securities. In a very broad sense, however, the term universal banks refers to those banks that offer a wide range of financial services, beyond commercial banking and investment banking, such as, insurance. However, universal banking does not mean that every institution conducts every type of business with every type of customer. Universal banking is an option; a pronounced business emphasis in terms of products, customer groups and regional activity can, in fact, be observed in most cases. In the spectrum of banking, specialized banking is on the one end and the universal banking on the other.

They are multi-product firms in the financial services sector whose complexity is difficult to manage. In their historical development, organizational structure, and strategic direction, universal Banks constitute multi-product firms, within the financial services sector. This stylized profile of universal banks presents shareholders with an anagram of more or less distinct businesses that are linked together in a complex network which draws on as set of centralized financial, information, human and organizational resources - a profile that tends to be extraordinarily difficult to manage in a way that achieves optimum use of invested capital.

Universal banking generally takes one of the three forms:

a. In-house Universal banking. Eg. Germany, Switzerland

BANK

Securities Investments

Mutual funds Insurance

Underwriting Advisory

b. Through separately capitalized subsidiaries. Eg. England, Japan.Bank

Subsidiary

c. Operations carried through a holding company ,Eg. USA, JapanBank Holding Company

Bank

Securities

History Of Universal Banking

Economic historians have long emphasized the importance of financial institutions in industrialization. More recently, economists have begun more intensive investigation of the links between financial system structure and real economic outcomes. In theory, the organization of financial institutions partly determines the extent of competition among financial intermediaries, the quantity of financial capital drawn into the financial system, and the distribution of that capital to ultimate uses. The choice between universal and specialized banking may affect interest rates, underwriting costs, and the efficiency of secondary markets in securities. Furthermore, the presence or absence of formal bank relationships may affect the quality of investments undertaken, strategic decision-making, and even the competitiveness of industry. Thus, financial systems theoretically can influence the costs of finance at two levels: general effects on the economy as a whole and localized influences on individual firms and industries. Modern problems in developing and transitional economies, diminishing regulatory barriers in the United States, and progressive economic integration in western Europe make it all the more important to understand the economic impact of financial system structure.

Particularly since World War II, many economists and historians have argued that German-style banks offer advantages for industrial development and economic growth. Universal banking efficiency combined with close relationships between banks and industrial firms, they hypothesize, spurred Germany's rapid development at the end of the nineteenth century and again in the post-World War II reconstruction. A corollary to this view holds that countries that failed to adopt the universal-relationship system suffered as a consequence. Adherents suggest that British industry has declined over the past hundred years or more, and that the American economy has failed to reach its full potential, due to short-comings of the financial system that lead to relatively high costs of capital (Kennedy, 1987, Chandler, 1990, and Calomiris, 1995).

In the 1990s, however, recession and bank-related scandals in Germany raised doubts about the benefits of universal banking systems. Even more recently, the introduction of the Euro seems to have brought the so-called bank-based systems a wave of market-oriented finance: IPOs, hostile takeovers, and corporate bond issues. Likewise, recent research questions many common beliefs about the organization and impact of the universal banks in the post-World War II German economy (Edwards and Fischer, 1994). Yet in the heat of the furious `battle of the systems,' large-scale international comparisons reveal no consistent relationship between financial system design and real economic growth in the late twentieth century (Levine, 2000).

India followed a very compartmentalized financial intermediaries allowed to operate strictly in their own respectively fields. However, in the 1980s banks were allowed to undertake various non-traditional activities through subsidiaries. This trend got momentum in the early 1990s i.e., after initiation of economic reforms with banks allowed to undertake certain activities, such as, hire-purchase and leasing in house. While this in a way represented a gradual move towards universal banking, the current debate about universal banking in India started with the demand from the DFIs that they should be allowed to undertake banking activity in-house. In the wake of this demand, the Reserve Bank of India constituted in December 1997, a working group under the chairmanship of Shri S.H. Khan, the Chairman & the Managing Director of IDBI (hereafter referred to as Khan Working Group-KWG). The KWG, which submitted its report in May 1998, recommended a progressive move towards universal banking. The Second Narsinham Committee appointed by Government in 1998 also echoed the same sentiment. In January 1999, the Reserve Bank issued a Discussion Paper setting out issues arising out of recommendations of the KWG and the Second Narsinham Committee. Since then a debate has been going on about universal banking in general and conversion of DFIs into universal banks in particular. With the opening up of the insurance sector to the private participation, the debate has gone beyond the narrow concept of universal banking.

UNIVERSAL BANKING IN SELECTED COUNTRIES

1) The traditional home of universal banking is Central and Northern Europe, in particular, Germany, Austria, Switzerland and Scandinavian countries. Universal banking in countries like Germany, Austria and Switzerland evolved in response to a combination of environmental factors besides regulation. The direct involvement of German banks in industry through equity holdings was the result partly of banks converting their loans into equity stakes in companies experiencing financial pressures. A combination of environmental factors and unique historical events enabled banks in different European countries to establish themselves in particular segments of the corporate financing market.

2) While countries like Germany and Switzerland never imposed any restriction on combining commercial and investment banking activities, the U.S. passed the Banking Act, 1933(Glass-Steagall Act has come to mean those sections of the Banking Act, 1933 that refer to banks securities operations), whereby banks were prohibited from combining investment and commercial banking activities. The Glass-Steagall Act was enacted to remedy the speculative abuses that infected commercial banking. The legal provisions of the Banking Act, 1933(Glass-Steagall Act) established a distinct separation between commercial banking and investment banking and made it almost impossible for the same organization to combine these activities.

3) The competition in the banking industry has intensified following financial deregulation and innovations and introduction of new information technologies.

4) The restrictions on banks engaged in securities business have been relaxed considerably worldwide during the last two decades. Three groups of countries can be distinguished. While countries, such as Germany, the Netherlands, and several Nordic countries, have imposed very little restriction on the combination of traditional banking and securities business, Canada and most European countries have entirely removed barriers to acquisition of securities firms and hence access to stock exchanges [Borio and Filosa, 1994]. Even in the U.S., where commercial and investment banking have been legally separated, market participants have tried to take advantage of some of the loopholes in the Glass-Steagall Act. For example, taking advantage of practices and institutional structure as well.

5) Universal banking usually takes one of three forms, i.e., in-house, through separately Capitalized subsidiaries, or through a holding company structure. Universal banking in its fullest or purest form would allow a banking corporation to engage in-house in any activity associated with banking, insurance, securities. Three well-known countries in which these three structures prevail are Germany, the U.K. and the U.S. In Germany, banking and investment activities are combined, but separate Subsidiaries. Statement 1: Universal Banking Practices in Select Countries

Type of UniversalBankingFeaturesCountries PracticingPosition in India

(1)(2)(3)(4)

I.Narrow Universal BankingCombination of commercial banking and investment bank- ing, i.e., issuing, underwriting, investing and trading securities.In India, presently there are no restrictions on banks investments in preference shares/non-convertible debentures/bonds of private corporate bodies. Banks are also allowed to invest in corporate stocks. However, such investments are restricted to 5 per cent of incremental deposit of the previous year. Banks are also allowed to underwrite, subject to the limit of 15 per cent of the issue size. In case there are devolvement and the aforementioned 5 per cent limit is exceeded, banks are required to offload the excess holdings. Banks are also allowed to own 100 per cent investment banks and undertake mutual fund activity through separate entities.

a)In-houseAustralia, Austria, Denmark, Finland, France, Germany, Hong Kong@, Pakistan#, Poland, Sweden, Switzerland

b)Through conglomerate route (By setting up subsidiaries)Brazil, Canada, China, Japan@@, Korea, Mexico, Netherlands, New Zealand, Norway$, Thailand, U.K.

c)Permitted to some extentChile*, Belgium

Like-wise, DFIs which have traditionally been engaged in the medium to long-term financing have recently started undertaking short-term lending including working capital finance. They have also been allowed to accept short to medium-term deposits in the form of term deposits and CDs, albeit within limits. DFIs have also set up subsidiaries for undertaking banking and various other activities. For instance, IDBI and ICICI have already set up banking subsidiaries and mutual funds, besides setting up subsidiaries in the field of investor services, stock broking registrars services. IFCI has also set up subsidiaries for undertaking merchant banking, stock broking, providing registrars services, etc.

d) Not permittedIn U.S., banks are permitted to deal in government securities; stock brokerage activities are also generally permitted; however, corporate securities underwriting and dealing activities must be conducted through specially authorised affiliates, which must limit such activities to 10 per cent of gross revenues.

Unit Trust of India, which has characteristics of both a mutual fund, and Development Financial Institution under a statute, also has a banking subsidiary. HDFC, a non-banking financial company (NBFC) has also set up a commercial bank.

@Except for limitation on shareholding in certain listed companies and subject to limits based on the capital of the bank.

#Except for some specifically disallowed securities.

@@Except for equity brokerage for the time being.

$Stock brokerage activities need no longer be conducted in separate subsidiaries.

*Certain activities through subsidiaries.

Statement 1: Universal Banking Practices in Select Countries

Type of UniversalFeaturesCountries PracticingPosition in India

Banking

(1)(2)(3)(4)

II.Broad UniversalCombination of commercial banking, investment banking and various other activities including insurance.

Banking

a)In-houseHongkong**, Poland, Sweden

Australia, Austria, Belgium, Brazil, Canada, China, Den- mark, France, Germany, Mexico, Netherlands, New Zealand, Norway, Portugal, Singapore##, Thailand, Spain, Switzerland, U.K.Presently insurance business in India is allowed only by LIC, GIC and its

subsidiaries.

b)Through conglomerate route (By setting up subsidiaries).

c)Permitted to some extentItaly***

d) Not permittedChile, Japan, Korea, Pakistan,

Panama, Peru, U.S.$$

**Subject to limits based on the capital of the bank.

##Locally incorporated banks may own insurance company with MASs approval.

***Limited to 10 per cent of own funds for each insurance company and 20 per cent aggregate investment in insurance companies.

$$Allowed through a separate holding company.

International Experience

The traditional home of universal banking is central and northern Europe, in particular, Germany, Austria, Switzerland and Scandinavian countries. Universal banking in countries like Germany, Austria and Switzerland evolved in response to a combination of environmental factors besides regulation. The direct involvement of German banks in industry through equity holdings was the result partly of banks converting their loans into equity stakes in companies experiencing financial pressures. A combination of environmental factors and unique historical events enabled banks in different European countries to establish themselves in particular segments of the corporate financing market

While countries like Germany and Switzerland never imposed any restriction on combining commercial and investment banking activities, the U.S. passed the Banking Act, 1933(Glass-Steagall Act has come to mean those sections of the Banking Act, 1933 that refer to banks securities operations), whereby banks were prohibited from combining investment and commercial banking activities. The Glass-Steagall Act was enacted to remedy the speculative abuses that infected commercial banking prior to the collapse of the stock market and the financial panic of 1929-33. The legal provisions of the Banking Act, 1933 (Glass-Steagall Act) established a distinct separation between commercial banking and investment banking and made it almost impossible for the same organisation to combine these activities.

The competition in the banking industry has intensified following financial deregulation and innovations and introduction of new information technologies. Regulators in many countries have decompartmentalised their credit systems by extending the range of permissible activities and removing legal and other restrictions.

The restrictions on banks engaged in securities business have been relaxed considerably worldwide during the last two decades. Three groups of countries can be distinguished. While countries, such as Germany, the Netherlands, and several Nordic countries, have imposed very little restriction on the combination of traditional banking and securities business, Canada and most European countries have entirely removed barriers to acquisition of securities firms and hence access to stock exchanges. Even in the U.S., where commercial and investment banking have been legally separated, market participants have tried to take advantage of some of the loopholes in the Glass-Steagall Act. For example, taking advantage of Section 20, banks have already been allowed to step into securities underwriting through separate affiliates. In comparison with deregulation concerning the combination of commercial and investment banking activities, deregulation relating to combination of banking and insurance business has been limited.

Universal banking usually takes one of three forms, i.e., in-house, through separately capitalised subsidiaries, or through a holding company structure. Universal banking in its fullest or purest form would allow a banking corporation to engage in-house in any activity associated with banking, insurance, securities, etc. That is, these activities would be undertaken in departments of the organisation rather than in separate subsidiaries. Three well-known countries in which these three structures prevail are Germany, the U.K. and the U.S. In Germany, banking and investment activities are combined, but separate subsidiaries are required for certain other activities. Under German banking statutes, all activities could be carried out within the structure of the parent bank except insurance, mortgage banking, and mutual funds, which require legally separate subsidiaries. In the U.K., broad range of financial activities are allowed to be conducted through separate subsidiaries of the bank. The third model, which is found in the U.S., generally requires a holding company structure and separately capitalised subsidiaries. Apart from the U.S. and Japan, where the separation between commercial banking and investment banking has been more rigid, there have been many other countries which continue to have restrictions on combining of commercial banking and investment activities. A synoptic view of universal banking practices prevailing in various countries including India is presented in Statement 1.

The following general observations can be made from Statement 1 on the practice of Universal Banking (UB).

First, the practice of UB varies across different countries.

Second, for convenience, it is possible to differentiate between UB in the narrow sense and in broader terms. The narrow definition of UB would combine lending activities and investment in equities and bonds/debentures. The broader definition would include all other financial activities, especially insurance.

Third, it is possible to envisage UB activities in-house or through subsidiary route, or even through a combination of in-house and subsidiary route.

Fourth, where it is predominantly through subsidiary route, it can be inferred that a conglomerate approach to financial services is invoked.

Fifth, in India, the regulatory environment permits provision of a range of financial services in-house in a bank subject to some restrictions. Banks have the option of undertaking investment activity, etc. through subsidiaries. DFIs have also been permitted to set up banking subsidiaries. DFIs are also permitted to operate at the short end of the market, by performing bank like functions, such as, providing working capital finance or tapping deposits, subject to some restrictions. In brief, both banks and DFIs are permitted, in a limited way, to undertake a range of financial services, at their option, in-house and through subsidiaries.

EMPIRICAL EVIDENCE

The empirical studies to test the existence of economies of scale in universal banks do not provide any conclusive evidence. Some studies found that the economies of scale in commercial banking were exhausted at very low deposit levels, i.e., less than 100 million dollars in deposit [Benston, Berger, Hanweck and Humphrey, 1983; Clark, 1988]. Noulas, Ray and

Miller [1990], in a study of North American banks, in which very small local banks were not included, found certain economies of scale for assets exceeding 600 million dollars. Some studies even show diseconomies [Mester, 1992 and Saunders and Walter, 1994]. Using the historical evidence of the 1980s, Saunders and Walter [1994] found that very large banks grew more slowly than the smallest among the big banks in the world.

The empirical evidence of economies of scope is also not clear. Though some studies suggest that economies of scope emerge with the joint use of information technologies [e.g. Gilligen, Smirlock and Marshall, 1984], such economies are admittedly small. It may be noted that there are also difficulties in measuring economies of scope. One could measure economies of scope only if the firms studied produce different kinds of output of sufficient variety to produce measurable differences in costs. Because most banks offer almost the same kinds and proportion of services, it is difficult, if not impossible, to conduct meaningful empirical studies of economies of scope [Benston, 1990].

While analysing the cost efficiency of universal banking in India, Ray [1994] found that the Indian banks have been gradually assuming the responsibility of developmental financing which is also cost efficient. The study clearly reveals that the banks have been found to realize overall scale economies if output is defined in terms of term loans, other loans and deposits.

Furthermore, the study also indicates the presence of substantial economies of scale with respect to the developmental banking activities and confirms the presence of scope economies for development financing among banks.

Thus, the empirical evidence available on economies of scale and scope, which the literature suggests, is not categorical. Historical experience as to whether universal banks are more risky offers contradictory evidence as detailed below:

i) In the U.S., during the banking crisis of the 1930s, universal banks that offered commercial and investment banking services had a lower rate of failures than the specialised banks. This was because the securities trading business provided a significant diversification of revenues [Benston, 1990].

ii) A critical examination of the financial crisis that affected Germany and France during the post-war period revealed that the financial crisis was not due to the presenc of universal banks. On the contrary, because of their diversity in their business, they could reduce the risks. Franke and Hudson [1984], who analysed the three most serious banking crises recorded in Germany in the 20 th century and their bearing on the universal banking system prevailing in that country, concluded that it did not seem possible to establish a close relationship between universal banks and financial crisis.

iii) Many banks suffered crises in several European countries during the recession of the second half of the 1970s and the recession of the early 1990s. The banks that suffered most from these recessions and went bankrupt were the medium and large sized universal banks and, in particular, universal banks that had major stakes in the industrial sector [Cuervo, 1988].

Although many German financial institutions offer almost all kinds of financial services, the universal banks do not dominate the market. The evidence from Germany indicates that universal banking does not result in limited sources of credit or other financial services. In Germany, both universal banks and specialised institutions offer their services to the public. For that matter, in no country, universal banks seem to have been able to eliminate specialized institutions from business.

In Germany, a 1979 Banking Commission Report (Gessler Commission) did not find universal banks exerting excessive influence. The checks and balances implicit in market competition among 4,000 financial institutions as well as insurance companies and other non-banks, together with German banking and commercial law, were found to be sufficient safeguards. The Gessler Commission, however, did find that universal banks had the information advantage obtained by them in the course of their credit business.

Regarding the overall efficiency of investment, Boyd, Chang and Smith [1998] found that under universal banking a larger portion of the surplus generated by externally financed investment accrues to banks and loss accrues to the originating investors. This clearly can have far-reaching implications for aggregate investment activity. They also demonstrated that problems of moral hazard in investment would often be of greater concern under universal banking than under commercial banking. In sum, the authors suggested universal banking could easily have adverse consequences for the overall efficiency of investment.

Universal Banking: Regulatory and Supervisory Challenges

Universal banking generally implies complexity of regulation and supervision. Following deregulation, domestic financial markets become closely inter-linked and a wide range of innovations and new products are introduced. These together with integration with international financial markets add one more dimension to sector activities and increase the problems of effective control by national regulators. These developments throw up policy challenges that are often too technical and for adequate understanding of their implications; detailed data and information are required. As the participants innovate newer products to circumvent the applicable regulatory constraints, more and more complex legal and administrative arrangements are required to be put in place for effective response. Correspondingly, regulatory institutions also need to be equipped with sufficient policy guidelines and resources to analyse and interpret vast amount of data and information very quickly.

Regulatory institutions and frameworks in many countries on the other hand, are traditionally compartmentalised and geared to overseeing specialised financial service providers. Rapid expansion in the size and the variety of financial activity let alone its complexity following deregulation, easily overwhelms the resources as well as the legal framework for regulation. The resultant lack of adequate supervision of the liberalised financial sector leads to serious distortions and malfunctioning.

A notable development in the 1980s and 1990s is the emergence of financial conglomerates providing a large range of financial services in various locations and this also includes banking, non-banking financial services, insurance, securities, asset management, advisory services, etc. Consequently, the job of the regulators becomes difficult because failure in any particular segment could easily spread to other parts and finally this could become systemic. The level of preparation of the regulatory mechanism to meet such contingencies also becomes challenging. In countries like Britain, efforts have already been made to move towards a unified regulatory authority for financial regulation with the responsibility for bank supervision, securities market, investments and insurance regulation. With further financial liberalisation reforms, the expectations of depositors and investors also increase. The experience to a greater extent suggests that with a view to minimising the contagion, it becomes imperative that the regulators adopt conglomerate approach to financial institutions.

Another important consideration that advocates caution in moving to universal banking relates to the possible impact of non-core banking activities on core banking activities. The core banking activities comprise accepting unsecured deposits from public and providing payment services as an integral part of the payment system in the economy. The central banks obligation to act as the lender of the last resort and maintain safety net to support banks in times of trouble follows from this relationship. Mixing of financial services and other banking activities with the core banking activities may result in substantial increase in the burden on the central bank on two counts. It might create expectation among public as well as investors that central banks safety net may be extended to all the activities of a bank in times of need. This would place far too much demand on the central banks resources, besides aggravating the problem of moral hazard. Second, commercial banks ability to fulfill its obligation in respect of its non-core activity (say, mutual fund) might affect depositors confidence in the bank, causing a run on the bank with possible adverse effects on the entire banking sector.

It is to maintain a distinction between the core and non-core banking activities that many authorities insist on a formal separation by requiring the two sets of activities to be carried out under separately capitalised subsidiary of a holding company. However, recent experience in the U.K. and the U.S. casts doubts on the efficacy of firewalls due to market perceptions as well as interdependencies between the two sets of activities when undertaken too closely together within a group structure. Historically, banks have been considered special for various reasons. In the evolution of financial sector in any type of economy, viz., industrial, developing and transition, banks are the first set of institutions to develop, followed by others, viz., investment banks, security houses, capital markets, insurance companies, etc. Hence due to their age, they are considered as a vital segment. Secondly, they mobilise deposits and hence are a major contributor in enhancing financial savings of the economy. In this context, the vast area of network they have, no doubt, helps them to mobilise savings not only from the urban centres, but also from the remote corners of the country. Thirdly, they assume an important position in the payment and settlement mechanism. In recent years, it has been the common practice to measure the strength of the economy by the effectiveness of payment and settlement mechanism. Hence the soundness of banks is continuously evaluated and remedial policies are put in place once any kind of weakness is identified. Even the IMF, World Bank and other international organisations give importance for banking soundness due to banks effective role in the payment and settlement system. Fourthly, banks are the principal source of non-market finance to various segments of the economy.

The experience the world over shows that major banks everywhere have increasingly diversified the products and services they offer, such as, investment banking, life insurance, etc., either in-house or through separate subsidiaries. However, even these developments have not fundamentally altered the special characteristics of banks. On the liability side, although some close substitutes for deposits, such as, money market mutual funds have taken place which have eroded banks market share as a repository for liquid asset holdings, such erosion has generally been very small and bank deposits still constitute a single largest source of liquid asset holdings. Even though in recent years some new facilities have been developed for making payments, such as, debit cards or credit cards, most transactions are still settled through banks. On the asset side, there is some evidence of a gradual erosion of the role of banks in financial intermediation. For instance, in the U.K., bank lending to the corporate sector declined from 27 per cent of total corporate borrowing outstanding in 1985 to less than 17 per cent recently, due mainly to larger corporate borrowers accessing domestic and international capital markets directly. Small corporates, on the other hand, continue to remain heavily dependent upon bank finance.

Thus, while there certainly have been important changes affecting banks and the environment in which they work, they have not yet been such as to substantially alter their key functions or the importance of those functions to the economy; nor have they altered fundamentally the distinctive characteristics of either the banks liabilities or their assets. In some respects, they may be less special than they were; they remain special nonetheless. They continue to remain special in terms of the particular characteristics of their balance sheets, which are necessary to perform those functions [Eddie George, 1997].

Economics of Universal Banking

From a production -function perspective, the structural form of universal banking appears to depend on the ease with which operating efficiencies and scale and scope economies can be exploited - determined in large part by product and process technologies - as well as the comparative organisational effectiveness in optimally satisfying client requirements and bringing

to bear market power.

Economies of Scale: Bankers regularly argue that 'Bigger is better' from a shareholder perspective, and usually point to economies of scale as a major reason.

Individually economies (diseconomies) of scale in universal banks will either be captured as increased profit margins or passed along to clients in the forms of lower (higher) prices resulting in a gain (loss) of market share. They are directly observable in cost functions of financial service suppliers and in aggregate performance measures.

Economies of Scope: Economies of scope arise in multi-product firms because costs of offering various activities by different units are greater than the costs when they are offered together. On the supply side, scope economies relate to cost-savings through sharing of overheads and improving technology through sharing of overheads and improving technology through joint production of generically similar groups of services.

On the demand side, economies of scope arise when the all-in cost to the buyer of multiple financial services from a single supplier - including the price of the service, plus information, search, monitoring, contracting and other transaction costs - is less than the cost of purchasing them from separate suppliers.

X-efficiency: Besides economies of scale and scope, it seems likely that universal banks of roughly the same size and providing roughly the same range of services may have very different cost levels per unit of output. The reasons may involve efficiency-differences in the use of labour and capital, effectiveness in the sourcing and application of available technology, and perhaps effectiveness in the acquisition of productive inputs, organisational design, compensation and incentive systems - and just plain better management.

Absolute Size and Market Power: Universal Banks are able to extract economic rents from the market by application of market power. Indeed, in many national markets for financial services suppliers have shown a tendency towards oligopoly but may be prevented by regulation or international competition from fully exploiting monopoly positions.

Value of Income -stream Diversification: There are potential risk-reduction gains from diversification in universal financial service organizations, and that these gains increase with the number of activities undertaken. The main risk-reduction gains appear to arise from combining commercial banking with insurance activities, rather than with securities activities.

Access to Bailouts: In such a case, failure of one of the major institutions is likely to cause unacceptable systemic problems. If this turns out to be the case, then too-big-to-fail organizations create a potentially important public subsidy for universal banking organizations and therefore implicitly benefit the institutions' shareholders.

Conflicts of Interest: The potential for conflicts of interest is endemic in universal banking, and runs across the various types of activities in which the bank is engaged:

Salesman's Stake: it has been argued that when banks have the power to sell affiliates' products, managers will no longer dispense 'dispassionate' advice to clients. Instead, they will have a salesman's stake in pushing 'house' products, possibly to the disadvantage of the customer.

Stuffing fiduciary accounts: A bank that is acting as an underwriter and is unable to place the securities in a public offering - and is thereby exposed to a potential underwriting loss - may seek to ameliorate this loss by stuffing unwanted securities into accounts managed by its investment department over which the bank has discretionary authority.

Bankruptcy - risk transfer: a bank with a loan outstanding to a firm whose bankruptcy risk has increased, to the private knowledge of the banker, may have an incentive to induce the firm to issue bonds or equities - underwritten by its securities unit - to an unsuspecting public. The proceeds of such an issue could then be used to pay-down the bank loan. In this case the bank has transferred debt-related risk from itself to outside investors, while it simultaneously earns a fee and/or spread on the underwriting.

Third party loans: To ensure that an underwriting goes well, a bank may make below-market loans to third party investors on condition that this finance is used to purchase securities underwritten by its securities unit.

Tie-ins: A bank may use its lending power activities to coerce or tie-in a customer or its rivals that can be used in setting prices or helping in the distribution of securities unit. This type of information flow could work in the other direction as well.

Issues In Universal Banking

Deployment of capital: If a bank were to own a full range of classes of both the firms debt and equity the bank could gain the control necessary to effect reorganization much more economically. The bank will have greater authority to intercede in the management of the firm as dividend and interest payment performance deteriorates.

Unhealthy concentration of power: In many countries such a risk prevails in specialized institutions, particularly when they are government sponsored. Indeed public choice theory suggests that because Universal Banks serve diverse interest, they may find it difficult to combine as a political coalition even this is difficult when number of members in a coalition is large.

Impartial Investment Advice: There is a lengthy list of problems, involving potential conflicts between the banks commercial and investment banking roles. For example there may be possible conflict between the investment bankers promotional role and commercial bankers obligation to provide disinterested advice. Or where a Universal Banks securities department advises a bank customer to issue new securities to repay its bank loans. But a specialized bank that wants an unprofitable loan repaid also can suggest that the customer issues securities to do so.

Advantages Of Universal Banking

The main argument in favour of universal banking is that it results in greater economic efficiency in the form of lower cost, higher output and better products. This logic stems from the reason that when sector participants are free to choose the size and product-mix of their operations, they are likely to configure their activities in a manner that would optimise the use of their resources and circumstances. In particular, the following advantages are often cited in favour of universal banking.

Economies of scale mean lower average costs which arise when larger volume of operations are performed for a given level of overhead on investment. Economies of scope arise in multi-product firms because costs of offering various activities by different units are greater than the costs when they are offered together. Economies of scale and scope have been given as the rationale for combining the activities. A larger size and range of operations allow better utilisation of resources/inputs. It is sometimes argued that acquisition of some information technologies becomes profitable only beyond certain production scales. Larger scale could also avoid the wasteful duplication of marketing, research and development and information-gathering efforts.

Due to various shifts in business cycles, the demand for products also varies at different points of time. It is generally held that universal banks could easily handle such situations by shifting the resources within the organisation as compared to specialised banks. Specialised firms are also subject to substantial risks of failure, because their operations are not well diversified. Proponents of universal banking thus argue that specialised banking system can present considerable risks and costs to the economy. By offering a broader set of financial products than what a specialised bank provides, it has been argued that a universal bank is able to establish long-term relationship with the customers and provide them with a package of financial services through a single window. It is important to note that this benefit stems from the very nature/purpose of universal banking.

Profitable Diversions. By diversifying the activities, the bank can use its existing expertise in one type of financial service in providing other types. So, it entails less cost in performing all the functions by one entity instead of separate bodies. Resource Utilization. A bank possesses the information on the risk characteristics of the clients, which can be used to pursue other activities with the same clients. A data collection about the market trends, risk and returns associated with portfolios of Mutual Funds, diversifiable and non diversifiable risk analysis, etc, is useful for other clients and information seekers. Automatically, a bank will get the benefit of being involved in the researching . Easy Marketing on the Foundation of a Brand Name. A bank's existing branches can act as shops of selling for selling financial products like Insurance, Mutual Funds without spending much efforts on marketing, as the branch will act here as a parent company or source. In this way, a bank can reach the client even in the remotest area without having to take resource to an agent. One-stop shopping. The idea of 'one-stop shopping' saves a lot of transaction costs and increases the speed of economic activities. It is beneficial for the bank as well as its customers. Investor Friendly Activities. Another manifestation of Universal Banking is bank holding stakes in a form : a bank's equity holding in a borrower firm, acts as a signal for other investor on to the health of the firm since the lending bank is in a better position to monitor the firm's activities.

Disadvantages of Universal Banking

Grey Area of Universal Bank. The path of universal banking for DFIs is strewn with obstacles. The biggest one is overcoming the differences in regulatory requirement for a bank and DFI. Unlike banks, DFIs are not required to keep a portion of their deposits as cash reserves. No Expertise in Long term lending. In the case of traditional project finance, an area where DFIs tread carefully, becoming a bank may not make a big difference to a DFI. Project finance and Infrastructure finance are generally long- gestation projects and would require DFIs to borrow long- term. Therefore, the transformation into a bank may not be of great assistance in lending long-term. NPA Problem Remained Intact. The most serious problem that the DFIs have had to encounter is bad loans or Non-Performing Assets (NPAs). For the DFIs and Universal Banking or installation of cutting-edge-technology in operations are unlikely to improve the situation concerning NPAs.

The larger the banks, the greater the effects of their failure on the system. The failure of a larger institution could have serious ramifications for the entire system in that if one universal bank were to collapse, it could lead to a systemic financial crisis. Thus, universal banking could subject the economy to the increased systemic risk.

Universal bankers may also have a feeling that they are too big to be allowed to fail. Hence they might succumb to the temptation of taking excessive risks. In such cases, the government would be forced to step in to save the bank. Furthermore, it is argued that universal banks are particularly vulnerable because of their role in underwriting and distributing securities.

Historically, an important reason for limiting combinations of activities has been the fear that such institutions, by virtue of their sheer size, would gain monopoly power in the market, which can have significant undesirable consequences for economic efficiency. Two kinds of concentration should be distinguished, viz., the dominance of universal banks over non-financial companies and concentration in the market for financial services. The critics of universal banks blame universal banking for fostering cartels and enhancing the power of large non-banking firms.

Some critics have also observed that universal banks tend to be bureaucratic and inflexible and hence they tend to work primarily with large established customers and ignore or discourage smaller and newly established businesses. Universal banks could use such practices as limit pricing or predatory pricing to prevent smaller specialised banks from serving the market. This argument mainly stems from the economies of scale and scope. Combining commercial and investment banking gives rise to conflict of interests as universal banks may not objectively advise their clients on optimal means of financing or they may have an interest in securities because of underwriting activities.

Saunders [1985] points out that conflict of interests might arise from the following:

(a) conflict between the investment bankers promotional role and the commercial bankers obligation to provide disinterested advice;

(b) Using the banks securities department or affiliate to issue new securities to repay unprofitable loans;

(c) Placing unsold securities in the banks trust accounts;

(d) Making bank loans to support the price of a security that is underwritten by the bank or its securities affiliate;

(e) Making imprudent loans to issuers of securities that the bank or its securities affiliate underwrites;

(f) Direct lending by a bank to its securities affiliate; and

(g) Informational advantages regarding competitors.

Conflict of interests was one of the major reasons for introduction of Glass-Steagall Act. Three well-defined evils were found to flow from the combination of investment and commercial banking as detailed below.

(a) Banks were deploying their own assets in securities with consequent risk to commercial and savings deposits.

(b) Unsound loans were made in order to shore up the price of securities or the financial position of companies in which a bank had invested its own assets.

(c) A commercial banks financial interest in the ownership, price, or distribution of securities inevitably tempted bank officials to press their banking customers into investing in securities which the bank itself was under pressure to sell because of its own pecuniary stake in the transaction.

The provisions of the Glass-Steagall Act were directed at these abuses. It is argued that universal banks are more difficult to regulate because their ties to the business world are more complex. In the case of specialised institutions, government/supervisory agencies could effectively monitor them because their functions are limited.UNIVERSAL BANKING IN INDIA

In India Development financial institutions (DFIs) and refinancing institutions (RFIs) were meeting specific sect oral needs and also providing long-term resources at concessional terms, while the commercial banks in general, by and large, confined themselves to the core banking functions of accepting deposits and providing working capital finance to industry, trade and agriculture. Consequent to the liberalisation and deregulation of financial sector, there has been blurring of distinction between the commercial banking and investment banking.

Reserve Bank of India constituted on December 8, 1997, a Working Group under the Chairmanship of Shri S.H. Khan to bring about greater clarity in the respective roles of banks and financial institutions for greater harmonization of facilities and obligations . Also report of the Committee on Banking Sector Reforms or Narasimham Committee (NC) has major bearing on the issues considered by the Khan Working Group.

The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to RBI to discuss the time frame and possible options for transforming itself into an universal bank. Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance, its proposed policy for universal banking, including a case-by-case approach towards allowing domestic financial institutions to become universal banks.

Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit their plans for transition to a universal bank for consideration and further discussions. FIs need to formulate a road map for the transition path and strategy for smooth conversion into a universal bank over a specified time frame. The plan should specifically provide for full compliance with prudential norms as applicable to banks over the proposed period.

IN The early Nineties the forces of globalisation were unleashed on the hitherto protected Indian environment. The financial sector was crying out for reform. Public sector banks which had a useful role to play earlier on now faced deteriorating performance. For these and certain other reasons private banking was sought to be encouraged in line with the Narasimham Committee's recommendations.

It would be pertinent to recapitulate the prevailing conditions in the banking industry in the early Nineties: the nationalised sector had outlived its utility; in fact they became burdened with unwelcome legacies; customer service had become a casualty; need for computerisation, including networking among the vast branch network was felt. Private banking in that context was viewed a brand new approach, to bypass the structural and other shortcomings of the public sector. A few of the new ones that were promoted by the institutions such as the IDBI and ICICI did establish themselves, though in varying degrees, surviving the market upheavals of the 1990.That was possible apart from other factors due to the highly professional approach some of them adopted: it helped them stay clear of the pitfalls of nationalised banking. Yet in less than a decade after the advent of these new generation banks, some of the successful ones, are being forced to change organisationally and in every other way. Who benefits after this restructuring is something that has to be asked.

It is essential to assimilate history of banking as well as the role of the financial institutions till recently. The branch banking concept with which we are familiar and practised since inception is basically on certain `protected' fundamentals. The insulated economy till the Nineties provided comforts to public sector banks, in areas of liquidity management while in an administered interest regime, discretion of managements was limited and consequently, the risk parameters in these spheres were hazy and not quantifiable. The share of private sector banks which is distinctly known as old private sector banks' established before 1994, was thus not substantial while operations of foreign banks were also restricted. Staff orientation especially at the branch level is a key ingredient for success and neither the older private banks nor the nationalised banks were successful in that respect.

The woes of the public sector banks till date relate to handling volumes, be it in the area of transactions or staff complement or branch offices. Post nationalisation, mass banking sans commercial or professional goals, indiscreet branch expansion, lack of networking, wide gaps/inefficiency at the levels of control apart from environmental impacts, contributed to their present status.

Turning to recent merger announcement between the ICICI and its more recently promoted banking subsidiary the following become relevant. One of the main motivations has been the need to access a low cost retail deposit base. Public sector banks, by way of contrast never had to face such a constraint.

Today, in a market driven economy, to face the competition, one factor is the size and hence, mergers are advocated. Talking of the PSBs it is relevant to note that except for a build up of savings accounts (as low cost deposits), the advantage of vast branch network is yet to be exploited by them while on the other hand, most of the complaints, irregularities, mounting arrears in reconciliation are attributable to such branch expansion.

At the same time, this has enabled a few of the smart foreign/new private sector banks to enrich themselves by offering cash management products, utilising the same branch network! All these pose a question to the recent merger of Bank of Madura - will the ICICI Bank decide to shed unwanted, unremunerative branches? Pertinently for all banks the RBI has already provided an exit route but there have been no takers among the public sector banks, for obvious reasons.

Pertinent again is to note that another set of banks, namely, foreign banks prospered during all these difficult days. Even today, these banks do not have branch network to speak of but in terms of volume, profitability they are far ahead of the public sector banks. Only a couple of new private sector banks have posed any challenge to them in the recent years.

Turning to recent merger announcement between the ICICI and its more recently promoted banking subsidiary the following become relevant. One of the main motivations has been the need to access a low cost retail deposit base. Public sector banks, by way of contrast never had to face such a constraint.

Today, in a market driven economy, to face the competition, one factor is the size and hence, mergers are advocated. Talking of the PSBs it is relevant to note that except for a build up of savings accounts (as low cost deposits), the advantage of vast branch network is yet to be exploited by them while on the other hand, most of the complaints, irregularities, mounting arrears in reconciliation are attributable to such branch expansion.

At the same time, this has enabled a few of the smart foreign/new private sector banks to enrich them by offering cash management products, utilising the same branch network! These entire pose a question to the recent merger of Bank of Madura - will the ICICI Bank decide to shed unwanted, unremunerative branches? Pertinently for all banks the RBI has already provided an exit route but there have been no takers among the public sector banks, for obvious reasons.

Pertinent again is to note that another set of banks, namely, foreign banks prospered during all these difficult days. Even today, these banks do not have branch network to speak of but in terms of volume, profitability they are far ahead of the public sector banks. Only a couple of new private sector banks have posed any challenge to them in the recent years.

Development financial institutions (DFIs) and refinancing institutions (RFIs) were meeting specific sectoral needs and also providing long-term resources at concessional terms, while the commercial banks in general, by and large, confined themselves to the core banking functions of accepting deposits and providing working capital finance to industry, trade and agriculture. Consequent to the liberalisation and deregulation of financial sector, there has been blurring of distinction between the commercial banking and investment banking.

Indian Banks pursuant to the nationalisation and state ownership of the main players took upon themselves the role of developoment bankers and diversified thier credit dispensations. Term Lending and credit delivery against hypothecaton of assets, which were unheard of earlier, came to be accepted as a common measure of credit policy. All sectors of Indian economy were brought under purview of banks' financial support. A group of banks joined together as a consortium and diversified risk in financing bulk ventures sharing portions both amonst themselves and also along with the Term Lending Institutions. The entry of banks into the realm of financial services was to follow very soon. The first impulses for a more diversified financial intermediation were witnessed in the late 1980s and early 1990s when banks were allowed to undertake leasing, investment banking, mutual funds, factoring, hire-purchase activities through separate subsidiaries. By the mid-1990s, all restrictions on project financing were removed and banks were allowed to undertake several activities in-house. Reforms in the Insurance Sector in the late Nineties and opening up of this field to private and foreign players, also resulted in permitting banks to undertake sale of insurance products. At present, only an 'arms-length' relationship between a bank and an insurance entity has been allowed by the regulatory authority, i.e. the Insurance Regulatory and Development Authority (Irda). Which means that commercial banks can enter insurance business either by acting as agents or by setting up joint ventures with insurance companies. And the RBI allows banks to only marginally invest in equity (5 per cent of their outstanding credit).

The phenomenon of universal banking as a distinct concept, as different from narrow banking, came to the fore-front in the Indian context with the second Narasimham Committee (1998) and later the Khan Committee (1998) reports recommending consolidation of the banking industry through mergers and integration of financial activities.

At this point it became relevant to consider opening Development finance Institutions to avail the options to involve in deposit banking and short-term lending as well. DFIs were set up with the objective of taking care of the investment needs of industries. They have, over time, built up expertise in merchant banking and project evaluation. Yet they have also backed bad investments and, as a result, become equity holders in defaulting enterprises through conversion of loans into equity. They also extend soft loans by way of equity contribution to medium and large industries. DFIs have developed core competence in investment banking. They take a lot of risks to prop up industries. They finance industries such as infrastructure industries, which have long gestation periods and have contributed significantly to the country's industrialisation process.

However the access of Developmental Finance Institutions to low cost funds has been denied. Saddled with obligations to fund long gestation projects, the DFIs have been burdoned with serious mismatches between their assets and liabilities side of the balance sheets. Their traditional lending to industries such as textiles and iron and steel has caused them serious problems at a time when the method of classifying balance-sheets has become more transparent. The Narasimham Committee (II) had suggested that DFIs should convert into banks or non-banking finance companies. Some of the issues addressed in the transition path relate to compliance with cash reserve ratio and statutory liquidity ratio requirements, disposal of non-banking assets, composition of the board, prohibition on floating charge of assets, restrictions on investments, connected lending and banking license.

Converting into UBs will grant them ready access to cheap retail deposits and increase the coverage of the advances to include short-term working capital loans to corporates with greater operational flexibility. The institutions can then effectively compete with the commercial banks. They will be able to attract more volumes because they meet most of the needs of their customers under one roof. Reserve Bank of India constituted on December 8, 1997, a Working Group under the Chairmanship of Shri S.H. Khan to bring about greater clarity in the respective roles of banks and financial institutions for greater harmonisation of facilities and obligations . Also report of the Committee on Banking Sector Reforms or Narasimham Committee (NC) has major bearing on the issues considered by the Khan Working Group.

The Commitee submitted comprehensive recommendations of which one was about Universal Banking. The working group made a strong pitch for "eventually" giving full banking licenses to the development financial institutions (DFIs) and called for mergers between strong banks and institutions. Till the time the DFIs are given full banking licenses, they should be permitted to have wholly-owned banking subsidiaries."Size, expertise and reach are now deemed crucial to sustained viability and future survival in the financial sector," the report says, and recommends that managements and shareholders of banks and DFIs be allowed to explore the possibility of gainful mergers not only of banks but also of banks and DFIs.

The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to RBI to discuss the time frame and possible options for transforming itself into an universal bank. Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance, its proposed policy for universal banking, including a case-by-case approach towards allowing domestic financial institutions to become universal banks.

Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit their plans for transition to a universal bank for consideration and further discussions. FIs need to formulate a road map for the transition path and strategy for smooth conversion into an universal bank over a specified time frame. A universal bank can be a single company, a holding company with wholly owned subsidiaries, a group of entities with cross-holdings or even a flagship company which may or may not have independent shareholders. The panel has argued that the regulator should not impose the appropriate corporate structure. Calling for an enabling regulatory framework to ensure the transition towards universal banking, the panel said a function-specific and institution-neutral regulatory framework must be developed. "This concept of neutrality should be applicable to both foreign and local entities," it said.

KHAN WORKING GROUP

In the light of a number of reform measures adopted in the Indian financial system since 1991, and keeping in view the need for evolving an efficient and competitive financial system, the Reserve Bank constituted on December 8, 1997, a Working Group under the Chairmanship of the then Chairman and Managing Director of Industrial Development Bank of India, Shri S. H. Khan, with the following terms of reference:

To review the role, structure and operations of Development Financial Institutions (DFIs) and commercial banks in emerging operating environment and suggest changes;

To suggest measures for bringing about harmonization in the lending and working capital finance by banks and DFIs;

To examine whether DFIs could be given increased access to short-term funds and the regulatory framework needed for the purpose;

To suggest measures for strengthening of organisation, human resources, risk management practices and other related issues in DFIs and commercial banks in the wake of Capital Account Convertibility;

To make such other recommendations as the Working Group may deem appropriate to the subject.

The Working Group submitted its interim Report in April and final Report in May 1998. In the Monetary and Credit Policy announced in April 1998, it was indicated that a Discussion Paper would be prepared which will contain Reserve Banks draft proposals for bringing about greater clarity in the respective roles of banks and financial institutions for greater harmonisation of facilities and obligations applicable to them. It was also mentioned that the Paper would also take into account those recommendations of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham) which have a bearing on the issues considered by the Khan Working Group (KWG).

The thrust of