Universal Banking

Introduction:
In developing countries, the supply of funds is mainly in the form of short-term deposit because of low-per capita income and low wealth accumulation. In contrast the demand for funds is in long-term nature, reflecting the need for industrial business investment and infra-structural investment. Nevertheless, commercial banks are dominant, while bond markets are underdeveloped. Hence, the maturity mismatch between the supply of funds and the demand for funds remains a fundamental problem. Without resolving this problem, either industrial development can not be sustained or banking crisis can frequently happen.

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The Financial Sector Scenario in India

Indian Financial System is broadly classified into two groups: 1. Organised sector 2. Unorganised sector The financial system is also divided into users of financial services and providers. Financial institutions sell their services to households, business and government who are the users of financial services. The providers of financial services are: 1. Central bank 2. Banks 3. Financial institutions 4. Money and Capital markets 5. Informal financial enterprises The organised financial system comprises the following subsystems: 1. The banking system 2. The co-operative system 3. Development banking system a. Public sector b. Private sector 1. Money markets 2. Financial companies/institutions The unorganised financial system comprises of moneylenders, indigenous bankers, lending pawn brokers, landlords, traders, etc. There are also a host of financial companies, investment companies, chit funds, etc. in the unorganised sector. The Central Bank or the government does not regulate these in a systematic manner.

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INDIAN

BANKING

SYSTEM

Banking in India has its origin as early as the Vedic period. It is believed that the transition from money lending to banking must have occurred even before Manu, the great Hindu Jurist, who has devoted a section of his work to deposits and advances and laid down rules relating to rates of interest. During the Mogul period, the indigenous bankers played a very important role in lending money and financing foreign trade and commerce. During the days of the East India Company, it was the turn of the agency houses to carry on the banking business. The General Bank of India was the first Joint Stock Bank to be established in the year 1786. The others, which followed, were the Bank of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued till 1906 while the other two failed in the meantime. In the first half of the 19th century the East India Company established three banks; the Bank of Bengal in 1809, the Bank of Bombay in 1840 and the Bank of Madras in 1843. These three banks also known as Presidency Banks were independent units and functioned well. These three banks were amalgamated in 1920 and a new bank, the Imperial Bank of India was established on 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 15th April 1980 six more commercial private sector banks were also taken over by the government. The Indian Banking system has The Reserve Bank of India (RBI) as the apex body for all matters relating to the banking system. It is the Central bank of India. It is the banker to all other banks.

Universal Banking

Functions of RBI: Currency issuing authority Banker to the Government Banker to other banks Framing of Monetary Policy Exchange control Custodian to Foreign Exchange and Gold Reserves. Developmental activities Research and Development in the banking sector.

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Classification of banks:

1. Non Scheduled Banks: These are banks which are not included in the Second Schedule of the Banking Regulation Act, 1965. It means they do not satisfy the conditions laid down by that schedule. They are further classified as follows: Central Co-operative Banks and Primary Credit Societies. Commercial Banks.

2. Scheduled Banks: They are banks which are included in the Second Schedule of the Banking Regulation Act, 1965. According to this schedule a scheduled bank: Must have paid-up capital and reserve of not less than Rs.500,000; Must also satisfy the RBI that its affairs are not conducted in a manner detrimental to the interests of its depositors. Scheduled banks are sub-divided as: State Co-operative Banks: Commercial Banks: These are Co-operatives owned and managed by the state. These are business entities whose main business is accepting deposits and extending loans. Their main objective is profit maximization and adding shareholder value.

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These are further sub-divided as: Indian Banks: These banks are companies registered in India under the Companies Act. Their place of origin is in India. These are also sub-divided as: 1. Public Sector banks: State Bank of India and its Subsidiaries: This group comprises of the State Bank of India (SBI) and its seven subsidiaries viz., State Bank of Patiala, State Bank of Hyderabad, State Bank of Travancore, State Bank of Bikaner and Jaipur, State Bank of Mysore, State Bank of Saurashtra, State Bank of Indore. Other Nationalised Banks: This group consists of private sector banks that were Nationalised. The Government of India Nationalised 14 private banks in 1969 and another 6 in the year 1980. Regional Rural Banks: The RBI established these in the year 1975 of Banking Commission. It was established to operate exclusively in rural areas to provide credit and other facilities to small and marginal farmer, agricultural laborers, artisans and small entrepreneurs. 2. Private Sector Banks: Old Private Sector Banks This group consists of banks that were established by the privy states, community organisations or by a group of professionals for the cause of economic betterment in their area of operations. Initially their operations were concentrated in a few regional areas. However, their branches slowly spread throughout the nation as they grew. New Private Sector banks:

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These banks were started as profit oriented companies after the RBI opened the banking sector to the Private sector. These banks are mostly technology driven and better managed than other banks. Foreign Banks These are banks that were registered outside India and had originated in a foreign country. Over the years, the structure of financial institutions in India has developed and become broad based. Today, there are more than 4,58,782 institutions channeling credit into the various areas of the economy.

The performance of Banks from 1999-2000 Assets: The rate of the sector further slowed down during this decade. The assets grew at a CAGR of 15.24 % from Rs.2636.93bn to Rs.11103.68bn. The growth rate however, was greater in the later part of the decade indicating future prospects of increase in growth. Deposits: The deposits grew from Rs.1820.47bn to Rs.9003.06bn at a CAGR of 16.69 %. There was a spurt in the last 3-4 years of the decade indicating improving trend. In this decade however, the savings accounts were the laggards in terms of growth at 13.34 % CAGR. The term deposits grew at 18.38 % and current deposits grew at 15.23 %. This reversal of trend in growth rates shows that the people are increasingly using banks to deposit money to be used for transaction motive. Net worth: The Net worth grew at a feverish pace of 36.60 % CAGR, the highest in last three decades. This was mainly because the RBI opened the Banking sector to Private sector. As many as 9 New Private Sector Banks started their

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operations in this period. They brought a lot of capital in the period 1993-95. However in the later half of the decade, capital growth was virtually nil. The Reserves grew at 37.54 % CAGR from Rs.26.36bn Rs.438.34bn. However, contrary to Capital the Reserves recorded exceptional growth in the later half of the decade due to improving profits of private as well as public sector banks. However the gap between reserves and capital is once again widening. The Financial Institutions have found these statistics very attractive. This has led them to jump into the short-term lending foray of the sector. Similarly, the commercial banks are facing great internal competition as well as competition from the foreign banks, squeezing their incomes, in turn. Hence, they are also looking at alternate sources of revenue. Consequently, there has been a blurring in the line of differentiation between the Commercial Banks and the Financial Institutions.

If the WTO agreement has to be fulfilled, the Indian financial sector will have to be opened up, protectionism minimised and foreign competition welcomed. The implication of such a move: competition would intensify in the financial services industry thus making survival possible only for the fittest. So, the only solution lies in the domestic FIs preparing themselves for the new era by turning themselves into universal banks and hastening the process of erasing the boundaries that separate commercial banks from FIs.

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Universal Banking: An Overview

Universal Banking includes not only services related to savings and loans but also investments. However in practice the term 'universal banks' refers to those banks that offer a wide range of financial services, beyond commercial banking and investment banking, insurance etc. Universal Banking is a combination of commercial banking, investment banking and various other activities including insurance. If specialised banking is the one end universal banking is the other. This is most common in European countries. 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. Universal banking has some advantages as well as disadvantages. The main advantage of universal banking is that it results in greater economic efficiency in the form of lower cost, higher output and better products. However larger the banks, the greater the effects of their failure on the system. Also there is 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. Also combining commercial and investment banking can gives rise to conflict of interests. Conflict of interest was one of the major reasons for introduction of Glass-Steagall Act in US. The motive of universal banking is to fulfill all financial needs of the customer under one roof. All the leading players in the financial sector will be aiming to become a one-stop financial shop.

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Services provided by a Universal Bank: Important Activities being Performed by Banks and DFIs
Activities being performed by Banks Commercial Banking or similar in nature Accepting chequable deposits Granting of loans and advances Investment Banking Other Financial Services

Investment in securities Factoring Underwriting of issues Hire-purchase Loan syndication Leasing Merchant banking Credit cards Dealing in gold Mutual fund Housing finance

DFIs

Granting long-term loans Underwriting and and advances subscribing directly to shares/debentures of corporate bodies. Granting short-term loans and advances/ working capital finance Accepting term-deposits and issuing CDs at prescribed terms and conditions.

Commercial banking Housing finance Credit Rating Custodial services Brokerage Investor services Registrars services Project consultancy Debenture trusteeship

These are the services that are provided by the Banks and the Development Financial Institutions in India. With the emergence universal banks a single bank will carry out all the services. There will be no distinction between a bank and a DFI. There will be a single column of services showing the commercial banking services, investment banking services and the other financial services.

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Universal banking in India

In India Development Financial Institutions (DFIs) and re-financing 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. The entry of the New Private Sector banks into the market changed the face of this industry. Nurturing collaborative ventures and paying strong emphasis on forex services, the private banks are globalising Indian banking business. Armed with strategic alliances with foreign collaborators, these banks have opened doors to new positive ideas, concepts and products. These private banks have set a trend for universal banking. For instance Global Trust Bank is the first Indian Bank to have equity participation from International Finance Corporation and Asian Development Bank. Similar trends are seen in Centurion Banks alliance with Keppel Bank, Singapore and HDFC Bank with NatWest Markets, United Kingdom. Recently ICICI successfully completed its ADR issue on New York Stock Exchange (NYSE). The intensification of competition in the banking industry as a result of growing private sector participation coupled with growing customer needs has spurred innovation resulting in new products and services. The private sector banks spearhead this "Innovation Revolution". The new private sector banks are targeting specific products and client group. However with the advent of foreign players participation, the private sector banks position stands threatened. With emphasis on service and technology, it is for the first time that Indian banks (mainly private) are challenging the foreign banks. These banks are

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making heavy use of technology to give good service at par with foreign banks but to a much wider clientele. Branch size has been reduced considerably by using technology thus saving manpower. This has resulted in an overall cost saving. In addition the Any Time Money (ATM) facility helps draw large customers to a branch. ICICI Bank has already launched DataBase Management (referring to using the database of existing clients to generate more revenues). The new private banks are on an expansion phase and are now moving into semi-urban areas and satellite towns to fulfill their branch expansion norms. ICICI bank, HDFC bank, GTB, IndusInd, BOP and UTI Bank have come out with IPOs as per licensing requirement. Their technological edge and product innovation has seen them gaining market share from the slower, less efficient older banks. The new private banks have been consistently gaining market shares from the public sector banks. 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 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

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time frame. The plan should specifically provide for full compliance with prudential norms as applicable to banks over the proposed period. In India the following DFIs and banks are frontrunners in the race to convert to Universal Bank are: Banks State Bank of India Canara Bank Bank of India Bank of Baroda Financial Institutions Industrial Credit and Investment Corporation of India (ICICI) Industrial Development Bank of India (IDBI) Export Import Bank (EXIM Bank) Industrial Finance Corporation of India (IFCI) Industrial Investment Bank of India (IIBI) ICICI is already a virtual bank with subsidiaries like ICICI Bank engaged in banking business. Thus with clearing of legal hurdles it just has to work out the modalities to formally call itself a universal bank. Similarly other DFIs are charting out aggressive plans to stay ahead in this race. Also recently Bank of Baroda, a commercial bank has indicated its intention to convert to a Universal Bank

Potential Benefits and Costs of Universal Banking

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Universal banking has some advantages as well as disadvantages. Merits and demerits of universal banking have been examined on theoretical grounds, and there have been some studies to test them on a firm basis. Some of the important conclusions emerging from a review of these are discussed below. ADVANTAGES 1. Choice of Size and Product Mix 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. 2. 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. 3. 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

Universal Banking

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. 4. Resources at hand: 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. 5. Customer Relationship Management: Due to the very nature of Universal Banks, i.e. all the products and services under the same roof, a very important requirement of better customer relationship will be easy to achieve. The banks will get closer to the customer and maintain a long bank-customer life. 6. Information advantages In establishing a relationship with a firm, the bank incurs the costs of gathering information about the firm and its investment opportunity before

Universal Banking

making the funding decision. Once this decision is made, a new stage of the bank-firm relationship begins; the bank starts monitoring the firm, making sure that it observes the conditions of the funding contract and, at the same time, gathering further information about the firm. As a result, bank financing tends to be more expensive than public financing, thus explaining why firms tend to avoid the former type of funding. Moreover, some firms may also avoid bank funding to avert the additional scrutiny that usually comes with it. Because of this, firms with a higher reputation (usually larger firms) tend to raise funding directly in capital markets, while smaller and younger firms tend to rely on banks.

Within that set-up, it is usually conjectured that universal banks have some advantages over specialised ones. By offering a broader set of financial products than a specialised bank, a universal bank can develop wider and longer-term relationships with firms. This enhancement of the bank-firm relationship may be a source of important gains to both parties. A wider bank-firm relationship may be a source of scope economies. It allows the bank to learn more about a firm by observing its behavior with respect to more financial instruments and it gives the bank the opportunity to use the information it collects by monitoring a firms checking account in various businesses rather than just in lending decisions. Furthermore, by offering a larger number of services, a universal bank has more instruments to consider in the design of financing contracts and more leverage over firms managerial discretion, thus reducing agency costs. The duration of the bank-firm relationship is also important. If both the bank and the firm expect to do business for a long time, then the bank is more willing to invest in gathering information about that firm and to spread the costs of such investment over a longer time horizon, reducing the up-front cost of capital to the firm. The information available about a firm, its financial needs and its reputation changes over its life cycle. As a result, a firms ability to raise funding through

Universal Banking

the various financial instruments available and its ability to access the different providers of funding also changes over its life cycle. In the early stages of their existence, because they are unknown, firms tend to rely heavily on retained earnings and on funding provided by their founders. After a successful beginning, firms start raising most of their funding from banks, usually through loans. At this stage, they are highly dependent on banks investment in information and on their monitoring services. As firms mature and develop a reputation they often divert to capital markets to raise funding, in many cases by issuing bonds initially and only some time later by issuing stock.15 In an evolution like that, unlike a specialised bank, a universal bank can fulfil a firms funding needs throughout its existence. This fosters a long-term relationship that can be beneficial to both parties. 7. Risk Reduction: There are potential risk-reduction gains from diversification in universal financial service organisations, 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.

LIMITATIONS

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The most frequent arguments for maintaining the separation between commercial banking and the securities business are that combining these activities would create serious conflicts of interest and would threaten the safety and soundness of the banking system. These arguments have a historical precedent: they were the main reasons invoked by the U.S. Congress for enacting the Glass-Steagall Act in 1933. 1. Impact of Failure on Economy: 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. 2. Undue Risk Taking: 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. 3. Monopoly: 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. The critics of universal banks blame universal banking for fostering cartels and enhancing the power of large nonbanking firms.

4. Predatory Pricing:

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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. 5. Conflict of Interest: 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. 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) (d) Placing unsold securities in the banks trust accounts; 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) (g) Direct lending by a bank to its securities affiliate; and Informational advantages regarding competitors.

Conflict of interests were one of the major reasons for introduction of GlassSteagall Act in US. 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.

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(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. 6. Multiple Regulatory Authorities: It is argued that universal banks are more difficult to regulate because their ties to the business world are more complex. Multiple regulatory authorities will be engaged monitoring the functioning of universal banks. Hence there will be multiple regulators making the set-up very complex. This is very reason why HDFC is refraining from converting itself into a universal bank according to Deepak Parekh. 7. 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.

Regulatory Environment

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The following table shows the existing regulatory and supervisory norms for Banks and Development Financial Institutions: Regulatory/Supervisory regimes Licensing
Any company wishing to commence banking business in India is required to obtain a license from the Reserve Bank. There is no licensing requirement for a DFI/RFI set up as a statutory body. However, those DFIs, which are set up under the Companies Act, are treated as non-banking finance companies (NBFCs) and as such are required to obtain a Certificate of Registration from the RBI. These norms are in force from the accounting year beginning April 1, 1993 in respect of six DFIs viz., IDBI, ICICI, IFCI, IIBI (IRBI), TFCI and Exim Bank and from April 1995 in respect of 3 refinancing institutions, viz., SIDBI, NABARD and NHB.

Banks

Financial Institutions

Asset Classification and Provisioning

Capital Adequacy

Exposure norms

Cash Reserve Ratio/Statutory Liquidity ratio Priority Sector Lending

Prudential norms relating to income recognition, asset classification and provisioning were prescribed from the year beginning April 1, 1992. Asset classification norms are based on objective criteria of record of recovery of interest and/or installment of principal. Assets have been classified into four categories, viz., Standard, Sub-standard, Doubtful and Loss Assets. Capital adequacy norms to banks were prescribed in 1992. All banks are required to maintain 9 per cent riskweighted capital adequacy ratio as on 31.3.00 and onwards. As per norms, exposure of a bank to a single borrower should not exceed 25 per cent of its net owned funds. The norm is 50 per cent for Group Borrowers (an additional 10 per cent for infrastructure projects). All scheduled commercial banks are required to maintain 11 per cent CRR and 25 per cent SLR of their net demand and time liabilities (NDTL). Indian commercial banks (both Public and private sector): Total priority sector advances:- 40% of net bank credit

All term-lending and refinancing institutions are required to maintain 9 per cent risk-weighted capital adequacy ratio from March 31, 2000. Exposure norms relating to a single borrower or a group of borrowers for major termlending institutions are in force since June 1997. These norms for DFIs are same as prescribed for banks. Not prescribed.

No priority sector targets have been prescribed.

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Asset Liability Management System (ALM) On-site Supervision

Off-site Supervision

CAMELS Ratings

Total agricultural advances:18% of net bank credit Advances to weaker sections:10% of net bank credit Foreign banks operating in India : Total priority sector advances:- 32% of net bank credit Advances to small scale industries:- 10% of net bank credit Export credit:- 12% of net bank credit Draft guidelines for putting in place ALM System in banks were issued in September 1998. Final guidelines on ALM System are in the process of being issued. The new approach to on-site inspection of banks has been adopted from the cycle of inspections commencing July 1997. It focuses on the mandated aspects of solvency, liquidity, financial and operational health, based on a modified version of the CAMEL model viz., CAMELS, which evaluates bankscapital adequacy, asset quality, management, earnings, liquidity and systems and control. As part of the new Supervisory strategy piloted by the Board for Financial Supervision (BFS), the Department of Banking Supervision of the Reserve Bank set up an off-site surveillance system in 1995 with the primary objective of monitoring the financial condition of banks in between on-site examinations, identifying banks which show financial deterioration and which could be in trouble in the near future and acting as a trigger for on-site examination of banks. Two Supervisory Rating Models based on CAMELS and CACS (Capital adequacy, Asset quality, Compliance and Systems) for rating of Indian commercial banks and foreign banks operating in India,

Asset-Liability Management guidelines for DFIs are under consideration.

DFIs and RFIs were brought within the supervisory jurisdiction of the Board for Financial Supervision (BFS) in April 1995.

Off-site Surveillance system is yet to be put in place.

CAMEL rating system is yet to be put in place.

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respectively, have been worked out. These ratings enable the RBI to identify the banks whose condition warrants special supervisory attention.

Based on these supervisory / regulatory guidelines, the RBI has issued guidelines for the conversion of Financial Institutions to Universal Banks.

Salient operational and regulatory issues to be addressed by the FIs for conversion into a Universal Bank Reserve requirements Compliance with the cash reserve ratio and statutory liquidity ratio requirements (under Section 42 of RBI Act, 1934, and Section 24 of the Banking Regulation Act, 1949, respectively) would be mandatory for an FI after its conversion into a universal bank. Permissible activities Any activity of an FI currently undertaken but not permissible for a bank under Section 6(1) of the B. R. Act, 1949, may have to be stopped or divested after its conversion into a universal bank. Disposal of non-banking assets Any immovable property, howsoever acquired by an FI, would, after its conversion into a universal bank, be required to be disposed of within the maximum period of 7 years from the date of acquisition, in terms of Section 9 of the B. R. Act. The property has to be for its own use if it has to be retained. Composition of the Board

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Changing the composition of the Board of Directors might become necessary for some of the FIs after their conversion into a universal bank, to ensure compliance with the provisions of Section 10(A) of the B. R. Act, which requires at least 51% of the total number of directors to have special knowledge and experience in:

Accountancy Agriculture and Rural Economy Banking Co-operation Economics Finance Law Small Scale Industry Any other matters in the opinion of RBI, which would be useful to the bank.

Prohibition on floating charge of assets The floating charge created on any property or an undertaking, by an FI, shall have to be discontinued on conversion to a universal bank, unless ratified by RBI as not being detrimental to the interest of the depositors of the bank under Section 14(A). Nature of subsidiaries If any of the existing subsidiaries of an FI is engaged in an activity not permitted under Section 6(1) of the B R Act, then on conversion of the FI into a universal bank, it will have to delink such subsidiary from the its operations since Section 19 of the Act permits a bank to have subsidiaries only for one or more of the activities permitted under Section 6(1) of B. R. Act. Restriction on investments

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An FI with equity investment in companies in excess of 30 per cent of the paid up share capital of that company or 30 per cent of its own paid-up share capital and reserves, whichever is less, on its conversion into a universal bank, would need to divest such excess holdings to secure compliance with the provisions of Section 19(2) of the B. R. Act. This section prohibits a bank to have holdings exceeding these limits. Connected lending Section 20 of the B. R. Act prohibits grant of loans and advances by a bank on security of its own shares or grant of loans or advances on behalf of any of its directors or to any firm in which its director/manager or employee or guarantor is interested. The compliance with these provisions would be mandatory after conversion of an FI to a universal bank. Licensing An FI converting into a universal bank would be required to obtain a banking license from RBI under Section 22 of the B. R. Act, for carrying on banking business in India, after complying with the applicable conditions. Branch network An FI, after its conversion into a bank, would also be required to comply with extant branch licensing policy of RBI under which the new banks are required to allot at east 25 per cent of their total number of branches in semi-urban and rural areas. Assets in India An FI after its conversion into a universal bank, will be required to ensure that at the close of business on the last Friday of every quarter, its total assets held in India are not less than 75 per cent of its total demand and time liabilities in India, as required of a bank under Section 25 of the B R Act.

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Format of annual reports After converting into a universal bank, an FI will be required to publish its annual balance sheet and profit and loss account in the in the forms set out in the Third Schedule to the B R Act, as prescribed for a banking company under Section 29 and Section 30 of the B. R. Act. Managerial remuneration of the Chief Executive Officers The appointment and the remuneration of the existing CEO may have to be reviewed with the approval of RBI in terms of the provisions of Section 35 B of the Banking Regulations Act. The Section stipulates fixation of remuneration of the Chairman and Managing Director of a bank by Reserve Bank of India taking into account the profitability, net NPAs and other financial parameters. Under the Section, prior approval of RBI would also be required for appointment of Chairman and Managing Director. Deposit insurance An FI, on conversion into a universal bank, would also be required to comply with the requirement of compulsory deposit insurance from DICGC up to a maximum of Rs.1 lakh per account, as applicable to the banks. Authorised Dealers Licence Some of the FIs at present hold restricted AD licence from RBI, Exchange Control Department to enable them to undertake transactions necessary for or incidental to their prescribed functions. On conversion into a universal bank, the new bank would normally be eligible for full-fledged authorised dealer licence and would also attract the full rigour of the Exchange Control Regulations applicable to the banks at present, including prohibition on raising resources through external commercial borrowings. Priority sector lending

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On conversion of an FI to a universal bank, the obligation for lending to priority sector up to a prescribed percentage of their net bank credit would also become applicable to it. Prudential norms After conversion of an FI in to a bank, the extant prudential norms of RBI for the all-India financial institutions would no longer be applicable but the norms as applicable to banks would be attracted and will need to be fully complied with. Mr. Devi Dayal, Special Secretary (Banking), while delivering a Keynote Address in a session on "Universal Banking" at the National Conference on Financial Sector Reforms: Banks and FIs organised by CII, had said that customers have to be the ultimate beneficiaries of Universal Banking. According to Mr. Dayal, the banks have no choice but to turn into universal banks in the future. He said, to facilitate this, there is a need for a proper regulatory framework. Mr. Devi Dayal was of the view that as institutions will be undertaking different kinds of activities, it will be necessary to have far more stricter supervision norms and stringent regulatory measures.

International View
Internationally, universal banks have been contrasted on a the basis of the their features. Hence we classify them as:

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Narrow Universal Banks and; Broad Universal Banks.

Narrow Universal Banks: Narrow universal banks are a combination of commercial banking and investment banking, i.e., issuing, underwriting, investing and trading securities Narrow universal Banks can further be classified as follows: Narrow Universal bank 1. In-house: a single entity providing all the services. Practicing Countries Australia, Austria, Denmark, Finland, France, Germany, Hongkong, Pakistan, Poland, 2. Through conglomerate route (By setting up subsidiaries) 3. Permitted to some extent 4. Not permitted Sweden, Switzerland. Brazil, Canada, China, Japan, Korea, Mexico, Netherlands, New Zealand, Norway, Thailand, U.K. Chile, Belgium In 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. Position in India: In India, presently there are no restrictions on banks investments in preference shares/non-convertible debentures/bonds of private corporate

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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 evolvements 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. Like-wise, DFIs, which have traditionally been engaged in the medium to longterm 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. Unit Trust of India, which has characteristics of 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. Broad Universal Banks: Broad Universal Banks are a combination of commercial banking, investment banking and various other activities including insurance. Broad Universal bank 1. In-house: a single entity providing all the services. Practicing Countries Hongkong, Poland, Sweden Australia, Austria, Belgium, Brazil, Canada, China, Denmark, France, Germany, Netherlands, Switzerland.

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2. Through conglomerate route (By setting up subsidiaries) 3. Permitted to some extent 4. Not permitted

Mexico, New Zealand, Norway, Portugal, Singapore, Thailand, Spain, U.K. Italy. Chile, Japan, Korea, Pakistan, Panama, Peru, U.S.

Position in India: Previously, only LIC, GIC and its subsidiaries allowed insurance business in India. The liberalization has allowed many banks and DFIs to offer insurance schemes. For e.g. ICICI has entered into a joint venture (JV) with United Kingdom based insurance company Prudential. ICICI Prudential is offering insurance to the people of India. The insurance sector is one of the fastest growing sectors in the financial services sector. An FDI like ICICI to become a Real Universal Bank shall have to offer all kinds of insurance schemes.

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Merger of ICICI Limited and ICICI Bank Limited.

Mr. K.V. Kamath, CEO of ICICI Limited, has recently voiced the intentions of ICICI Limited towards banking and ICICI Bank. ICICI Limited is endeavoring to forge a closer relationship with ICICI bank. Mr. K V Kamath recently quoted in a leading daily " Banking is dead. Universal banking is in offering with a whole range of financial products and services. The basic idea is for banks to do business along with "banking". Bankers will have to emerge as businessmen." ICICI Bank is a focused banking company coping with the changing times of the banking industry. So it can be a lucrative target for other players in the same line of operations. However, when merged with ICICI Limited the attraction is reduced manifold considering the magnitude of operations of the ICICI Limited. ICICI Group The Industrial Credit and Investment Corporation of India Limited now known as ICICI Ltd. was founded by the World Bank, The Government of India and representatives of private industry on January 5, 1955. The objective was to encourage and assist industrial development and investment in India. Over the years, ICICI has evolved into a diversified financial institution. The ICICI Group draws its strength from the core competencies of its individual companies. Today, top Indian Corporates look towards ICICI as a business partner for providing solutions to their varied financial requirements. The Group also offers a gamut of personal finance solutions to individuals. To lead the financial services industry into the new millennium, the Group is now truly positioned as a Virtual Universal Bank. The liberalization of the Indian economy in the 1990s offered ICICI an opportunity to provide a wide range of financial services. For regulatory and strategic reasons, ICICI set up specialized subsidiaries in the areas of commercial banking, investment

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banking, non- banking finance, investor servicing broking, venture capital financing and state level infrastructure financing. The ICICI Group comprises of:

The following companies carry out the other activities: ICICI: Bonds, loans, corporate finance, and infrastructure finance ICICI Personal Financial Services: Retail Loan Distribution ICICI Home: Housing Finance ICICI Brokerage: Broking and equity research ICICI Kinfra: Infrastructure financing in Kerala ICICI Winfra: Infrastructure financing in West Bengal ICICI International: offshore investment and fund management ICICI Knowledge park: infrastructure and support facilities ICICI Bank ICICI Bank is a commercial banking outfit set up by the ICICI Group. The Bank was registered as a banking company on January 5, 1994 and received its banking license from the Reserve Bank of India on May 17, 1994. The Bank has an authorised capital of INR 300 crore (USD 75.96 million), of which subscribed and paid-up capital is INR 165 crore (USD 41.78 million).

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The first branch of ICICI Bank was started in Madras in June 1994. As of March 31, 1999, 64 branches were functional across the country. By this year 36 more branches/offices are expected to be added to the network. The branches are fully computerized with state-of-the-art technology and systems. All of them are fully networked through V-SAT (Satellite) technology. The Bank is connected to the international SWIFT network since March 1995. ICICI Bank offers a wide spectrum of domestic and international banking services to facilitate trade, investment, cross-border business, and treasury and foreign exchange services. This is in addition to a whole range of deposit services offered to individuals and corporate bodies. ICICI Bank's Infinity was the first Internet banking service in the country, and a prelude to banking in the next millennium. Currently the Bank has around 150,000 customers. Need for merger of ICICI Ltd. and ICICI Bank The recent trend in world banking is towards mergers and acquisitions. This is evident from the mergers occurring in Japan, United States and other parts of the world. The need is being felt for stronger and fewer players, offering a wide gamut of service (universal banking). With competition becoming acute and foreign banks entering the Indian market steps have to be taken to sustain growth in the Indian Banking sector. Mergers are recognised as an imperative for the survival of banks. A merged banking entity is, more often than not a universal bank is, often greater than the sum of its parts. As banks across the globe have realised, there are several variables that add upto synergies including economies of scale, market share, financial muscle, larger capital cushions, consolidation etc. The concept of mergers is not new to Indian banks. It has been on the reforms agenda since 1991, when the Committee on the Financial System,

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headed by the Reserve Bank of India 's former Governor chalked out a comprehensive blueprint for banking reforms. The 1997 report on bank restructuring has received an encouraging response. So, ICICI Bank has threat not only from private and foreign banks but from public sector banks also. Further with the emergence of customer satisfaction as a goal and intense competition as a phenomenon in the banking sector, the banks to keep themselves ahead in the race need to improve their services and innovate customer friendly products. In order to grow in this sector the players will be on a lookout for mergers and acquisitions. As ICICI bank fits into the overall strategy of ICICI Ltd., a defense strategy against any take-over attempt would be to either increase the stakes of the parent or to merge the subsidiary with the parent, the two possible ways of conversion into a universal bank. In short the threat of takeover for ICICI Bank can be classified under the following heads: De-regulation: Markets regimented by regulation are integrating. Walls between Financial Institutions (FIs) and Banks are crumbling. Banks are venturing into diversified areas and the concept of universal banking is the concept of the day. Globalization: Competition from abroad is also set to intensify. The foreign banks are looking to expand beyond their narrow niches to acquire retail reach. Restrictions on branch expansion of the foreign banks are being relaxed in line with the commitments made to the World Trade Organisation, under the Financial Services Agreement, by India. The reach of existing banks would enhance the foreign banks' network. Given their undoubted financial muscle and technical expertise, the foreign banks are likely to dominate the new markets for derivative securities and loan syndication that are bound to mature in the Indian economy. Unless Indian banks are strengthened through a process of mergers, they will concede market share to the foreign banks. This increases

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the risk of takeover for ICICI Bank and to consolidate its position, it may be advisable for the parent to merge the subsidiary into the parent or vice-versa, whichever is possible. Danger of being already diversified: As capital markets deepen and widen, the core banking functions come under attack. And the number of alternative savings vehicles multiply, limiting bank deposits growth. To survive, banks need to diversify into non-investmentbased activities and concentrate on upcoming areas like insurance, internet banking and house financing. ICICI is a pioneer in internet banking thus making it a lucrative target for the other banks. Volatility: As markets mesh together, both locally and internationally, prices become more volatile and risk mushrooms. A large capital-base provides the necessary cushion to withstand nasty shocks. The Public sector banks' dominance is eroding, forcing the former leaders to consider mergers to regain their supremacy. With the regulators opting for stringent capital adequacy requirements and the budgetary support through re-capitalization dwindling, the poorly- capitalized public sector banks would like to trigger off a merger wave. As higher levels of capital backing are vital, which mergers can achieve, mergers are gaining popularity. Suitability Test The suitability test involves the following five analyses 1. Life Cycle analysis 2. Positioning analysis 3. Value Chain analysis 4. Portfolio analysis 5. Business profile analysis Life Cycle analysis:

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The question whether the merger will fit in the life cycle of the area of operation is answered. The days of aggressive growth are over. Faced with the worst ever scrutiny of their balance sheets the banks are now hard-pressed to clean up their tarnished image. Indian banking is under threat as never before. Americans typically prefer to invest in mutual funds rather than in bank deposits. With the introduction of cheque facility in money market mutual funds in India, the next decade will see deposits being diverted from banks to mutual funds. However, the pace of growth could be slow. While disintermediation and thinning spreads are already knocking crores off banks' bottom lines, the entry of tele banking, ATMs and Internet banking has also neutralized their sole competitive strength-retail spread. But for true prosperity, banks will have to do something more than embrace technology. They have to look at opportunities beyond their current horizon of borrowing and lending. Feebased incomes would hold the key to customer retention. In this case as ICICI Bank is a sister of the ICICI group carrying out related activities in the financial sector. It has already ventured into new avenues like Internet banking. Thus a positive score for the merger in this analysis. Positioning Analysis: To ascertain whether the positioning is viable, this analysis is undertaken. In the US, more than 40% of bank revenues are from fee-based businesses. The same is the case in other developed countries. The trend is picking up in India also. Objective Interests of Strategies Segment Business NPA Mgt. Concentration HR policy Credit Rating What's IN Profitability Shareholders Pro-active Target banking Fee based Recovery mgt. cell Investments Hire & Fire Individual What's OUT Developmental & social Priority sector Passive Mass banking Fund based Credit monitoring cell Advances Job Security Corporate

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As ICICI Bank is a leading private player emphasizing more on what's in rather than what's out in the banking sector. Thus this merger is beneficial for the parties concerned. Value Chain Analysis: 1) Does it improve value for money? 2) Does it exploit the core competence? The answer to the first query is positive that is reflected in the financial statements of the annual reports. The core competence of the ICICI Group is financial services and ICICI Bank is a part of this group dealing in commercial banking. Spreads in traditional lending businesses are shrinking and are expected to align with international levels of 1.8-2% from the existing 2.8% over the next decade. Modern banks offer several advantages in terms of set-up and running costs. They offer, on an average, a 50% cost benefit. The benefits of Net Banking are evident. Besides convenience, costs per transaction are also low, just 10% of traditional banking. ICICI Bank as ventured into these areas. Thus the merger of ICICI Limited and ICICI Bank scores in this analysis also. Portfolio Analysis: Does it strengthen the balance of activities? As this Bank is already a part of the portfolio of ICICI Limited and a larger stake would not affect the balance of activities. Business Profile: Will it lead to good financial performance? As the functioning of ICICI Bank would not be largely affected by this merger and with greater competition the financial performance of the combined entity is expected to be satisfactory.

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Newspaper articles regarding ICICI's proactive approach towards Universal Banking:

FIIs, investors upbeat at ICICI, ICICI Bank merger plan Economic Times; aug21, 2001 CHENNAI: ICICI has received favourable response from Indian investors and FIIs on its move to merge with ICICI Bank and become a universal bank, according to Kalpana Morparia, executive director, ICICI. Interacting with media persons here today, she said Crisis has reaffirmed its triple A rating for ICICI and FIIs also expects its profit margins to improve after the merger due to the access to low cost deposits and the scope to increase income from fee-based activities. She said ICICI has to obtain a separate banking licence from RBI for becoming a universal bank. It has not yet filed any application. She envisaged a timeframe of 12 to 18 months for the process to be completed. There are already lot of operational synergies between us. We have created fire walls and functioning as separate legal entities only for complying with statutory obligations, she noted. ICICI was the first one to propagate universal banking as an ideal concept for the DFIs to support industries with low cost funds. There is clear demarcation in the operation of ICICI and the bank. The bank takes care of liabilities of less than one year by offering short term loans to corporates and personal loans, whereas medium to long term products like home loans, auto loans are handled by the parent. There is absolute co-ordination between them while marketing the products. She said ICICI has started increasing its international presence and associating closely with NRI community in various countries. ICICI Infotech is based in the US and has an office in Singapore. ICICI Securities has been registered as a broking firm in the US. ICICI Bank is leveraging on the strong network of 400 branches and extension counters and 600 ATMs for offering various products to NRIs. Extent of NRI deposits received by the bank comes to Rs 50 crore per month while it gets Rs 150 crore per month as rupee remittance from them. It offers them a novel facility by which the NRIs can transfer their money to 200 locations in India by internet. The payment will be made within 72 hours. It also offers loan products for helping their relatives in India. Besides, the Visa card helps them to withdraw cash through the ATM network. Morparia said NPA of banks in India are less than 10 per cent of GDP when compared to emerging economies like China, Korea and Thailand. But, the issue is overplayed in India. It should not be compared with developed countries like Europe and US. ICICIs gross NPA comes to Rs 6,000 crore. However, 97 per cent of this pertains to companies for whom it made the first disbursement prior to 1996.

ICICI to reduce arms to 12 in universal banking foray

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Sourav Majumdar & Sitanshu Swain Mumbai, Sept 2: The countdown to ICICI Ltds much talked about universal banking foray has begun. The financial institution has decided to further reduce the number of its subsidiaries from the present 21-plus to around 12 in its bid to turn into a universal bank in a span of 12-18 months. Alongside, the internal brainstorming to decide the nature of concessions ICICI would seek from the Reserve Bank of India (RBI) while becoming a universal bank, would also be initiated shortly. ICICI would require anywhere between Rs 18,000 crore to Rs 20,000 crore to meet its regulatory requirements for complying with the cash reserve ratio (CRR) and statutory liquidity ratio (SLR) norms when it turns into a bank. Speaking to the Financial Express, ICICI managing director and CEO K.V. Kamath said ICICI had already moved ahead on many points in its bid to provide a basic infrastructure to its universal banking dream. For instance, it has already brought in fresh capital to the tune of Rs 3,000 crore and has provided aggressively to clean up the balance sheet and also diversify the portfolio. Besides, ICICIs cutting-edge technology has also been used to empower the marketing efforts to push the brand. It is now time to give character to these efforts under a single window. The phrase universal banking has been interpreted by many people in many ways and made into an issue. There is no issue, really. The way we see it, it is the ability to conduct a host of banking activities under one roof with one brand, said Mr Kamath Elaborating, he said the American model was to combine commercial banking with retail banking, and the European model was to combine insurance, investment banking and other forms with commercial banking. But it is not the question of the model we adopt. I am saying whichever is the appropriate model, let us migrate to that, Mr Kamath said. He said already there was a move to cut down on the number of subsidiaries in ICICI from around 30 to 21. Eventually, as it turns into a universal bank, ICICI would like to have about 12 subsidiaries, Mr Kamath said. ICICI has subsidiaries like I-Sec, ICICI Personal Finance, ICICI Home Finance, ICICI Prudential Life Insurance, ICICI Web Trade and many others for a range of financial services. Mr Kamath said the key organisational steps towards this transition have already been taken recently after ICICI effected a huge across-the-board reshuffle among the top brass of ICICI and ICICI Bank. Some key executives have been posted at the bank in preparation of this change, and some have been brought from the bank to the parent institution as part of this recast. Besides, ICICI is also giving finishing touches to its major globalisation strategy, slated to be unveiled very shortly. Mr Kamath, however, ruled out the induction of a foreign partner in the post universal bank scenario. The RBI roadmap for universal banking makes it clear that compliance with the CRR and SLR norms is mandatory as an FI turns into a bank. Alongside, it also specifies that in the process of the transition, the FI would have to delink or shed such activity in which subsidiaries may be engaged, which are not in consonance with activities specified for bank subsidiaries in the existing Banking Regulation Act. Mr Kamath said that ICICI would have to examine the difficulties in raising the huge resources of about Rs 20,000 crore of CRR and SLR in such a short span of time of about 18 months. The issue is how we can raise that kind of funds in such a span of time, he said, indicating that this was one area where the institution may be asking for some leeway from the RBI.

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ICICI to merge financial companies Times of India, Sept 17, 2001; NEW DELHI: ICICI said on Monday that the group was exploring possibilities of merging its financial companies, including ICICI Ltd and ICICI Bank, within 12 to 18 months as part of its plans to become a universal bank. "The group is expecting to go for universal banking in about one-and-a-half years," ICICI managing director K.V. Kamath told newspersons here. "It (universal banking) is essentially a thought. We have plans to provide all products under one roof," he said. The Universal Banking concept is presently under consideration of the Reserve Bank of India (RBI). After RBI approval, the FI would inform the Securities Exchange Commission of the US as both ICICI and ICICI Bank are listed on the NYSE. ICICI's insurance ventures - Prudential ICICI and ICICI Lombart - would, however, be out of the universal bank. Leading financial institutions like ICICI, HDFC and IDBI had submitted a "common paper" to the government and the RBI for conversion into universal banks within the next few years. RBI is considering their proposals. As part of the common paper, the FIs had proposed that infrastructure lending be regarded as priority sector lending and statutory liquidity ratio (SLR) and cash reserve ratio (CRR) be considered on an incremental basis. Commenting on ICICI's financial health, Kamath said that the FI would bring down its nonperforming assets (NPAs) ratio to below 5 per cent of total deposits this fiscal as against about 5.2 per cent last fiscal, while maintaining a healthy 15-20 per cent growth in loan sanctions to about Rs 67,300 crore. ICICI capital adequacy ratio is also at a comfortable level of 15 per cent. Kamath said that the FI expected to maintain its growth despite the slowdown in the economy. "Slowdown is there but we have diversified in other sectors to maintain our growth," he said, adding ICICI credit offtake was about 6 per cent despite the lower industrial growth. ICICI's santions are expected to reach Rs 67,300 crore this fiscal as against Rs 56,092 crore last fiscal, while disbursements are likely to be about Rs 38,300 crore as compared to Rs 31,965 crore in 2000-01.

Organization Structure of a Universal Bank

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The potential benefits and costs of allowing banks and DFIs to undertake securities activities largely depend on the latitude they have to integrate these activities with their current mix of businesses. This latitude in turn depends on the freedom banks have in placing the securities activities within their organisational structure. A universal Bank can be formed in two ways: 1) In-house; 2) Subsidiary.
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Both the forms have certain advantages and disadvantages.

In-house: 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. Advantages of having a In-house universal bank:

Economies of Scope: Since all the activities are carried out in the same entity, there is maximum opportunity for the bank to have economies of scope. No Additional Capital: The bank does not need to pump in capital on order to start a new department i.e. another function. This leads to a huge cost saving.

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Disadvantages of having a In-house universal bank:

Conflict of Interest: There may be occurrence of a lot friction among the departments due to conflict of interest. Cover for Loss Making Departments: The accounts may not be shown pertaining to every individual department. Hence, if a certain department is making losses, in the annual reports these losses may not be reflected, covered by the profits of the other departments.

Banks can completely integrate the activities they choose to undertake because they can conduct all of them within a single corporate entity. Subsidiarization: The most frequently chosen modes under the subsidiary form are:

Bank Parent Company: A Bank with a securities subsidiary. Holding Company: A Holding Company with a banking subsidiary and a securities subsidiary, both separate entities.

In both these forms, commercial banking activities and securities activities are conducted in legally distinct entities with separate management teams and separate capital. As a result, integration can only be partially achieved. It is constrained further when there are restrictions on the financial and operational relationships between the bank and the securities subsidiary. There is corporate separateness due to the existence of separate entities. This brought about more often than not by the regulations applicable to the banks. Advantages of Subsidiarization:

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No Conflict of Interest. Specialization can be achieved in the respective function. Disadvantages of Subsidiarization: Capital Expenditure: The company will have to invest into a lot of capital cost of setting up the subsidiary. No Economies of Scope: The company will not be able to exploit the scope economies due to the corporate separateness. Perception of markets: However, some of the benefits claimed to emerge with corporate separateness have been questioned because markets do not perceive the units of a conglomerate to be independent of each other despite their being legally and operationally separated. The reason is that the conglomerate has an incentive to manage its units as an integrated entity rather than as a portfolio of independent firms in order to exploit the economies of scope. Examples of Practicing Countries: 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 is 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

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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. In INDIA: 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. ICICI Ltd calls itself a "Virtual Universal Bank". ICICI Bank was the subsidiary of ICICI Ltd, only recently has ICICI Ltd sold of its stake in the Bank, which has made the ICICI Bank a non-subsidiary of ICICI Ltd. ICICI Limited is in the process of merging (Reverse merger) the parent company with the bank.

Issues, Observations and Suggestions

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On the basis of the growth of universal banking, norms applicable for its growth, the financial institutions taking the initiative to convert themselves into universal banks, the financial structure of the economy and the international experience, a few issues related to universal banking in India have gained great importance. Some important points in this regard are: Prudential norms:

Both the Khan committee and the Narasimhan committee have recommended a level playing field for the DFIs in order to harmonise their activities with those of the banks. At present, the prudential norms, which are applicable to the banks, are not applicable to the DFIs. The Cash Reserve Ratio (CRR) and the Statutory Reserve Ratio (SLR) are applicable only to the banks. The DFIs do not have to maintain such reserves, because they are not governed by the Banking Regulation Act. The committees have recommended that these norms should also be applicable to the DFIs if they want to convert into universal banks. The reason being that it would be unfair to the banks if the DFIs are permitted to disburse working capital and other short term requirements. DFIs like ICICI and IDBI have voiced their opinion that they do not wish to maintain cash and statutory reserves. They believe that they will be hard pressed if the prudential norms on CRR and SLR were applied to them. ICICI would require anywhere between Rs 18,000 crore to Rs 20,000 crore to meet its regulatory requirements for complying with the cash reserve ratio (CRR) and statutory liquidity ratio (SLR) norms when it turns into a bank.

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A recent newspaper article on IDBI says that IDBI will not be able to convert itself into a universal bank unless the RBI provides some leeway in this matter. Thus, it becomes absolutely imperative for RBI to reduce the CRR rates to the bare minimum and the SLR rates should be brought down to NIL in accordance to the international rates. This will also make the institutions feel that RBI is positive and encouraging. Level playing field for banks and DFIs:

The banks have access to short term funds in the form of low cost retail deposits, on the other hand the soft window through which the DFIs used to get finance has been shut by the RBI. After reforms and financial sector liberalisation, the difficulty faced by DFIs is that the RBI has more or less completely shut down its soft-financing window known as the LTO (Long-Term Operations) Fund. This made available extremely low-cost funds for long maturities to DFIs. The DFIs had a captive base of investors earlier but with the reforms the government and the banks were given the freedom to not buy the bonds of the financial institutions. Thus, today the DFIs have to raise funds from the market increasing the cost of funds as compared to a bank. Trouble is, that in the absence of long-term debt markets in this country, longterm assets have to be funded by short-term funds. That creates a situation tailor-made for maturity mismatches. The RBI can stipulate all the assetliability management techniques in the world, yet so long as this fundamental problem remains; FIs will be exposed to serious risks. If the RBI wants to leverage universal banking in India, it has to take steps in order to reduce the cost of funds for the financial institutions. Only allowing the institutions to accept retail deposits can do this.

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RBI's view:

RBI Governor, Mr. Bimal Jalan had been quoted as saying that the time is not ripe for universal banking. Inspite the recommendations of the Khan Working Group, RBI felt that it would be better to adopt universal banks after a gap of 5 years. A standstill approach for five years may only push even the better DFIs down the path of ``adverse selection'' in their search for business and profits and add to their portfolio of assets of dubious quality. This danger is very applicable to ICICI as it has really shown a strong intent to convert. It has been proactive in every sense and needs encouragement and support from RBI. RBI needs to rethink its plan so that ICICI and other institutions are not discouraged. It should provide all the help and guidance required to such institutions for rapid transition.

Timeframe for conversion:

There has been debate as to by when should the DFIs become universal banks. The various committees have given a timespan of 5 years for such conversion. This is absolutely ridiculous because this depends upon the financial institutions. If the financial institution is not at terms with the financial structure of the economy then it will take more than 5 years. So if it doesnt convert into a universal bank within these 5 years will it not be allowed to convert into one later? The timeframe required thus depends entirely on the initiatives if the financial institutions. Long term funding by Commercial Banks?

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Over the years, DFIs have emerged as the pre-eminent source of expertise and experience in term lending and have developed considerable specialisation in project formulation, risk management and project monitoring. The important question here is whether banks will be able to provide long term funds to the corporates. Historically, banks have been in the short term lending end of the market and have gained specialisation in that. Banks will have to gain experience in order to specialize in long term requirements. While gaining this experience they may suffer losses by not recognising the fraudulent customers due to inexperience. RBI should consider this and give some space to the banks. Banks will take a longer time to become universal banks as compared to DFIs. Flexibility by Corporatisation:

The Narasimham Committee recommended that to provide the much needed flexibility in its operations, IDBI should be corporatised and converted into a joint stock company under the Companies Act on the lines of ICICI, IFCI and IIBI. Internationally there has been a wave of consolidation and convergence in the banking sector. India is also going to experience this wave of mergers and acquisitions. To facilitate this the financial institutions should be corporatised. As they will gain a free hand under the Companies Act. Human Resource Aspect:

A very important issue in this change towards universal banking is of managing change. All the other issues have overshadowed this issue. The mergers and acquisitions will lead to a lot employment changes, retrenchments, lay-offs.

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RBI hasn't given any importance to such a sensitive issue. Hence the RBI should lay down policies, also the required amendments should be done in the relevant applicable Act. Regulating authority:

"There is SEBI for capital market intermediaries, Reserve bank for banks and Registrar of companies for NBFCs. How could one meet all the regulatory norms under one umbrella organization?" HDFC Chairman Deepak Parekh once questioned the choice of becoming a universal bank by quoting that the benefit of evolving as a universal bank is minimized by the multiplicity of regulatory bodies for each segment of the markets. HDFC has not taken the initiative due to such problems, which put the future of universal banks in jeopardy. Hence for universal banks there should be only one regulating authority making it easier to govern such huge organizations.

Future of Universal Banking

What will be the future of the Indian financial institutions? Will more and more of the institutions embrace the concept of universal banking? Or will there be consolidation among the players to restrict the competition? These are quiet a few questions that arise particularly after the restructuring exercise taken-up by the ICICI. The consolidation move at ICICI will give further impetus to the movement of financial institutions towards universal banking. HDFC, IDBI have already started working on the concept of universal banking. The financial institutions have been subjected to immense changes in the last eight years. Almost all the institutions have moved closer to the retail markets. And the major beneficiaries of the changes in the markets have been the customers. Customers have become the critical determinants of the long-term relevance

Universal Banking

and profitability of the financial institutions. The process of restructuring would go on endlessly and with each twist and turn, each put together and tear apart action would be customer-centric. The distinction between the banks and NBFCs is fast narrowing due to the opening of the financial markets. In this context, the RBI is of the opinion that the financial institutions are at the crossroads of their future growth prospects. The traditional division between banks and FIs is increasingly getting blurred with the integration of financial markets and technology. RBI has already undertaken number of policy measures relating to the prudential regulation and supervision of term lending and refinancing institutions. The move by the RBI may go a long way in providing the services that they have been waiting for. There is a fascinating congruence of the scenario that each of these institutions and players assume: a surge in retail services with a significant migration of the wholesale business to offshore markets. This migration will be a blessing in disguise for the investors. India's retail customer is under-banked, under-securitised, under-insured and not the least underserviced. It is irrespective of the shape of the FIs in India they will continue to run their businesses and earn their earnings by meeting the expectations of 190 million households. Whatever, may be the strategies that the institutions take up in the future, India is going to witness growth in all the segments of retail banking industry. Also the growth of mutual funds, pension funds and insurance policies will make the FIs to think more about the transformation they have to undergo. Institutions such as the ICICI group, IDBI, HDFC that have a credible presence in retail banking are more likely to succeed in other retail businesses.