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INDIAN BANKING INDUSTRY

Banking falls under credit market and in India it is mainly governed by the Banking Regulation
Act, 1949 and RBI Act, 1934. The Reserve Bank of India and the Government of India exercise
control over banks from the opening of banks to their winding up by virtue of the powers
conferred under these statutes.

I. Legal frame work of regulation of banks:

The business of Banking:

1] Definition:

Banking is defined in section 5(b) of Banking Regulation Act, 1949 as the acceptance of deposits
from public for the purpose of lending or investment. Such deposits may be repayable on
demand or for a period of time as agreed by the banker and the customer.

2] Acceptance of deposits by Non-Banking entities:

There are also non-banking companies, firms and other unincorporated associations of persons
and individuals who accept deposit from the public. Acceptance of deposits by non-banking
financial companies is regulated by the Reserve Bank of India under the directions issued by it
under chapter 111B of the Reserve Bank of India Act. Other companies are regulated by the
central government under the companies (acceptance of deposits) rules, issued under section 58A
of the Companies Act.

3] License for banking:

In India, it is necessary to have a license from the Reserve Bank of India under section 22 of the
Banking Regulation Act for commencing or carrying on the business of Banking. Every banking
company has to use the word Bank as a part of its name and no company other a banking
company can use the words, Bank, Banker, Banking as a part of its name.
4] Permitted Business:

Although, traditionally the main business of the banks is, acceptance of deposits and lending, the
banks have now spread their wings far and wide into many allied and even unrelated activities.
Some of the important forms of business permissible are:

i borrowing, raising, or taking up of money

ii lending or advancing of money either upon security or without security

iii drawing, making, accepting, discounting, buying, selling, collecting and dealing in
bills of exchange, hundis, promissory notes, coupons, drafts, bills of lading, railway
receipts, warrants, debentures, certificates, scrips and other instruments and securities
whether transferable or negotiable or not

iv providing of safe deposit vaults

v collecting and transmitting of money and securities and other businesses as


permissible under section 6(1).

5] Prohibited Business:

Section 8 of the Banking Regulation Act prohibits Banking Company from engaging directly or
indirectly in trading activities and under taking trading risks.

Buying or selling or bartering of goods directly or indirectly is prohibited.

II. Constitution of Banks:

Banks in India fall under one of the following categories

i Body corporate constituted under special statutes:

ii Company registered under the Companies Act, 1956 or foreign companies.

iii Co-operative society registered under the Co-operative societies Act.


Public Sector:

The public sector banks including nationalized banks, State Bank of India and its associates and
the Regional Rural Banks fall in the first category. The Banking Companies Act, 1970
nationalized and vested them in newly created statutory bodies. The regional rural banks are
constituted under the Regional Rural Banks Act, 1976. These banks are governed by the statute
creating them as also some of the provisions of the Banking Regulation Act and The Reserve
Bank of India Act.

Banking companies:

A banking company, as defined in section 5(e) of the Banking Companies Act, is a company
which transacts the business of banking. Such company may be a company constituted under
section 3 of The Companies Act or a foreign company within the meaning of section 591 of that
act. All the private sector banks are Banking Companies. These banks are governed by The
Companies Act, 1956 in respect of their constitution and by the Banking Regulation Act and the
RBI Act with regard to their business of banking.

Domestic Scenario

In recent years Indian Banking industry has seen significant changes. Internet, wireless
technology and global straight-through processing have created a paradigm shift in the banking
industry. The growing market is attracting more and more foreign banks to enter Indian
territories. Recently there are 40 foreign banks in India and by 2009 few more will be added in
the list. RBI is planning to move from large number of small banks to small number of large
banks. With the economic growth picking up pace and the investment cycle on the way to
recovery, the banking sector will have to transform its role as an intermediary between the
demand and supply of funds. In order to speed up the growth process in the economy, the banks
need to play a greater and diversified role in the economy in the coming years.
In India, the most significant achievement of the financial sector reforms is the improvement in
the financial health of commercial banks in terms of capital adequacy, profitability and asset
quality as well as greater attention to risk management. Later on, after adopting the policy of
deregulation, it opened the new opportunities for the banks to increase revenues by diversifying
into investment banking, insurance, credit cards, depository services, mortgage financing,
securitization, etc.

During the same time, banks faced a greater competition both domestic and foreign, as well as
competition from mutual funds, NBFC, etc. due to liberalization. Increasing competition has
reduced the profitability and forcing the bank to work efficiently on shrinking spreads. As now
banks benchmark themselves against global standards, they have increased the disclosures and
transparency in bank balance sheets, the banks also started focusing more 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, and exposure limits investment fluctuation reserve, etc.

Reduction in pre-emptions lowering of reserve requirements (SLR and CRR), thus


releasing more lendable resources which banks can deploy profitably.

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.

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

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.

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 up to 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%.
Challenges Ahead

(i) Improving profitability: The most direct result of the above changes is increasing
competition and narrowing of spreads and its impact on the profitability of banks. The challenge
for banks is how to manage with thinning margins while at the same time working to improve
productivity which remains low in relation to global standards. This is particularly important
because with dilution in banks equity, analysts and shareholders now closely track their
performance. Thus, with falling spreads, rising provision for NPAs and falling interest rates,
greater attention will need to be paid to reducing transaction costs. This will require tremendous
efforts in the area of technology and for banks to build capabilities to handle much bigger
Volumes.

(ii) Reinforcing technology: Technology has thus become a strategic and integral part of
banking, driving banks to acquire and implement world class systems that enable them to
provide products and services in large volumes at a competitive cost with better risk management
practices. The pressure to undertake extensive computerisation is very real as banks that adopt
the latest in technology have an edge over others. Customers have become very demanding and
banks have to deliver customised products through multiple channels, allowing customers access
to the bank round the clock.

(iii) Risk management: The deregulated environment brings in its wake risks along with
profitable opportunities, and technology plays a crucial role in managing these risks. In addition
to being exposed to credit risk, market risk and operational risk, the business of banks would be
susceptible to country risk, which will be heightened as controls on the movement of capital are
eased. In this context, banks are upgrading their credit assessment and risk management skills
and retraining staff, developing a cadre of specialists and introducing technology driven
management information systems.
(iv) Sharpening skills: The far-reaching changes in the banking and financial sector entail a
fundamental shift in the set of skills required in banking. To meet increased competition and
manage risks, the demand for specialised banking functions, using IT as a competitive tool is set
to go up. Special skills in retail banking, treasury, risk management, foreign exchange,
development banking, etc., will need to be carefully nurtured and built. Thus, the twin pillars of
the banking sector i.e. human resources and IT will have to be strengthened.

(v) Greater customer orientation: In todays competitive environment, banks will have to strive
to attract and retain customers by introducing innovative products, enhancing the quality of
customer service and marketing a variety of products through diverse channels targeted at
specific customer groups.

(vi) Corporate governance: Besides using their strengths and strategic initiatives for creating
shareholder value, banks have to be conscious of their responsibilities towards corporate
governance. Following financial liberalisation, as the ownership of banks gets broad based the
importance of institutional and individual shareholders will increase. In such a scenario, banks
will need to put in place a code for corporate governance for benefiting all stakeholders of a
corporate entity.

Macroeconomic scenario and its impact on bank credit

Reduced impact of corporate credit as a growth driver- During 2004-05 the key
growth driver of the bank credits were housing, retail and priority sector credit and not
corporate credit. The large corporate with higher credit ratings continued to rely on
internal accruals, efficient treasury management and credit substitution of their funding
needs. This prompted banks to shift their attention to mid-corporate. Banks also
awakened to the big business opportunity presented by farm and rural lending and Small
and Medium Enterprise (SMEs).

Pressure of soft lending rates on margins On the supply side the monetary stance in
favour of providing appropriate liquidity to meet credit growth meant that lending rates
retained their soft bias, necessitating banks to constantly monitoring the mix of their
credit portfolios to protect their interest spreads.
Interest rates hardened - Interest rates hardened from the historically low levels to
which they had dropped in 2003-2004. This signaled an end to the run

Of investment profit that bank has been enjoying over the last two years returning the
focus of the bankers to the core activity of lending.

Changing in the geographical and demographical patterns of credit growth- There


were indications of changing in the geographical and demographical patterns of credit
growth. The major metros continue to account for a sizeable chunk of the credit growth,
the pace and depth of the credit absorption in the non-metros has been steadily picking up
in the last 5 years. Demographically, improved transportation and communication
connectivity together with rising economic aspirations and a greater willingness to use
personal debt to fund a better quality of life have stimulated credit demand in non-metros
and rural areas.

Banks now need to pick up a higher share of infrastructure lending - The


transformation of development financial institutions into a universal bank has created a
gap in financing infrastructure sector that is now growing at a brisk pace. This is
requiring banks to step in to fill the gap and take no longer tenure exposure in their loan
book with attendant demands on their assets liability management systems.

BASEL II NORMS

In year 1988, minimum capital standards, known as the Basel Capital Accord were lay down, to
ensure a minimum capital required to be maintained by internationally active banks. Though the
Basel Committee has only 13 members, but the fact is that more than 100 countries implemented
its capital standards. The original accord, now known as Basel-I, was quite simple and adopted a
straight-forward `one size fits all approach' that does not distinguish between the differing risk
profiles and risk management standards across banks. In June 1999, the Basel Committee issued
a proposal for a New Capital Adequacy Framework to replace the 1988 accord.

According to RBI's all the banks will have to implement the new Basel accord (Basel II) from
March 31, 2007. This will put Indian banks on virtually the same timetable as those in many
developed countries. According to Basel II more emphasis will be given to banks own internal
risk management methodologies, supervisory review and market discipline, while in the existing
capital accord focused on single risk measure.

The Basel II Accord comprised of three pillars:

Calculate minimum capital requirements using careful internal estimates of a range of


risk factors, such as probability of default and loss given default (Pillar I of the Accord)

Include a wider range of risks in their minimum capital requirement, especially exposure
to operational risks. (Pillar I)

Link a comprehensive assessment of the risks they face to the amount of economic
capital they hold (Pillar II)

Disclose risks and risk methodologies to the financial markets (Pillar III)

The Challenges of Implementing Basel II

Improvement to Credit Rating Process

Accurate Credit Factor estimation and calibration among many different portfolios

A sound approach to Operational Risk.

An efficient strategy for data gathering and management.

An overarching economic capital framework for enterprise risk management.

RBI is, however, much more cautious over the menu of risk measurement options that will be
available to the banks it supervises. Even at India's largest banks it is assumed that the RBI will
not sanction the more sophisticated risk measurement techniques for at least a further two years
after the new rules come into effect. According to N. Balaraman, head of risk management State
Bank of India, country's largest bank, has been using internal risk models for some years and has
good data on its corporate borrowers.
"Many banks would like to migrate to the A-IRB approach, but the Reserve Bank of India is not
keen on letting them do so because it does not want a differentiated system in which some banks
are on the advanced approach and others are on the standardized approach," says Vineet Gupta a
senior Bombay-based bank analyst at ICRA, a ratings agency partly owned by Moody's.

A study done by ICRA estimates that Indian bank will need additional capital of Rs.120 billion
($2.8 billion) to meet the Basel II operational risk capital requirement. 27 public sector banks
need Rs.90 billion, followed by the seven new generation private sector banks Rs.11 billion, and
the old generation of private sector banks Rs.7.5 billion.

The biggest problem for the sector is that there are just too many banks. And with many of them
government-owned, the scope for consolidation is limited.

Banking in India originated in the first decade of 18th century with The General Bank of India
coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are
now defunct. The oldest bank in existence in India is the State Bank of India being established as
"The Bank of Calcutta" in Calcutta in June 1806. Couple of decades later, foreign banks like
HSBC and Credit Lyonnais started their Calcutta operations in the 1850s. At that point of time,
Calcutta was the most active trading port, mainly due to the trade of the British Empire, and due
to which banking activity took roots there and prospered. The first fully Indian owned bank was
the Allahabad Bank set up in 1865.

By the 1900s, the market expanded with the establishment of banks like Punjab National Bank,
in 1895 in Lahore; Bank of India, in 1906, in Mumbai - both of which were founded under
private onwership. Indian banking sector was formally regulated by Reserve Bank of India from
1935. After India's independence in 1947, the Reserve Bank was nationalized and given broader
powers.

The next significant milestone in Indian Banking happened in the late 1960s when the then
Indira Gandhi government nationalizd, on 19th July, 1969, 14 major commercial Indian banks,
followed by nationalization of 6 more commercial Indian banks in 1980. The stated reason for
the nationalisation was more control of credit delivery. After this, until the 1990s, the
nationalised banks grew at a leisurely pace of around 4%-also called as the Hindu growth of the
Indian economy.

Banking Reforms since 1992

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.

The most significant achievement of the financial sector reforms has been the marked
impovement 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, securitisation, etc. At
the same time, liberalisation 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. A 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.

Trends
The Indian banking industry is currently in a transition phase. On the one
hand, the public sector banks, which are the mainstay of the Indian banking
system, are in the process of consolidating their position by capitalising on
the strength of their huge networks and customer bases. On the other, the
private sector banks are venturing into a whole new game of mergers and
acquisitions to expand their bases.

The system is slowly moving from a regime of large number of small banks
to small number of large banks. The new era will be one of consolidation
around identified core competencies.

In India, one of the largest financial institutions, ICICI, took the lead towards
universal banking with its reverse merger with ICICI Bank a couple of years
ago. Another mega financial institution, IDBI, has also adopted the same
strategy and has already transformed itself into a universal bank. This trend
may lead to promoting the concept of a financial super market chain, making
available all types of credit and non-fund facilities under one roof or
specialised subsidiaries under one umbrella organisation.

Growth statistics

Scheduled Commercial Banks (SCBs) in India are categorised into five


different groups according to their ownership and / or nature of operation.
These bank groups are (i) State Bank of India and its associates (ii) other
nationalised banks (iii) regional rural banks(iv) foreign banks and (v) other
Indian SCBs (in the private sector).

The banking sector witnessed strong growth in deposits and advances during
the year 2004-05. As of March 2005, the number of commercial banks stood
at 289. The aggregate deposits of SCBs increased from US$ 331 billion in
March 2004 to US$ 374 billion in March 2005; credit increased from US$ 185
billion to US$ 242 billion; and investments swelled from US$ 149 billion to
US$ 162 billion.

Net domestic credit in the banking system has witnessed a steady increase
of 17.5 per cent from US$ 445 billion on January 21, 2005 to US$ 523 billion
on January 20, 2006. The growth in net domestic credit during the current
financial year up to January 20, 2006 was 14.4 per cent.

Nationalised banks were the largest contributors to total bank credit at 47.8
per cent as of September 2005. While foreign banks' contribution to total
bank credit was low at 6.7 per cent, the contribution of State Bank of India
and its associates accounted for 23.8 per cent of the total bank credit. Credit
extended by other SCBs stood at 18.9 per cent.

Banks and consumer finance

Indian banks, particularly private banks, are riding high on the retail
business. ICICI Bank and HDFC Bank have witnessed over 70 per cent year-
on-year growth in retail loan assets in the second quarter of 2005-06. Annual
revenues in the domestic retail banking market are expected to more than
double to US$ 16.5 billion by 2010 from about US$ 6.4 billion at present,
says a McKinsey study.

The home loan sector is also on a smooth course. The average loan size of
home finance companies is increasing. HDFC, the second largest player in
the home finance business, has seen average loan increase from US$ 10,773
in FY04 to US$ 13,467 in FY05, a change of almost 25 per cent. For ICICI
Bank, which is the largest player in the business, the average ticket size is
about US$ 13,467 US$ 15,711 and has increased by 10-15 per cent over
last year.

Foreign banks are working on expanding their bases in the country. The
Ministry of Finance and Reserve Bank of India have agreed to allow foreign
banks to open 20 branches a year as against 12 now. At present, 40 odd
foreign banks have over 225 branches in India. At the end of 2004-05, the
total assets of foreign banks aggregated US$ 30 billion or 6.9 per cent of the
assets of all scheduled commercial banks. They will also be allowed 74 per
cent stake in private banks. After 2009, the local subsidiaries of foreign
banks will be treated on par with domestic banks.

Challenges facing Banking industry in India

The banking industry in India is undergoing a major transformation due to changes in economic
conditions and continuous deregulation. These multiple changes happening one after other has a
ripple effect on a bank trying to graduate from completely regulated sellers market to completed
deregulated customers market.

Deregulation: This continuous deregulation has made the Banking market extremely
competitive with greater autonomy, operational flexibility, and decontrolled interest rate and
liberalized norms for foreign exchange. The deregulation of the industry coupled with decontrol
in interest rates has led to entry of a number of players in the banking industry. At the same time
reduced corporate credit off take thanks to sluggish economy has resulted in large number of
competitors battling for the same pie.

New rules: As a result, the market place has been redefined with new rules of the game. Banks
are transforming to universal banking, adding new channels with lucrative pricing and freebees
to offer. Natural fall out of thist. skill building has led to a series of innovative product offerings
catering to various customer segments, specifically retail credit.

Efficiency: This in turn has made it necessary to look for efficiencies in the business. Banks need
to access low cost funds and simultaneously improve the efficiency. The banks are facing pricing
pressure, squeeze on spread and have to give thrust on retail assets.

Diffused Customer loyalty: This will definitely impact Customer preferences, as they are bound
to react to the value added offerings. Customers have become demanding and the loyalties are
diffused. There are multiple choices, the wallet share is reduced per bank with demand on
flexibility and customization. Given the relatively low switching costs; customer retention calls
for customized service and hassle free, flawless service delivery.

Improving profitability: There is increasing competition and narrowing of spreads and it is


having an impact on the profitability of banks. The challenge for banks is how to manage with
thinning margins while at the same time working to improve productivity which remains low in
relation to global standards. This is particularly important because with dilution in banks equity,
analysts and shareholders now closely track their performance. Thus, with falling spreads, rising
provision for NPAs and falling interest rates, greater attention will need to be paid to reducing
transaction costs. This will require tremendous efforts in the area of technology and for banks to
build capabilities to handle much bigger volumes.

Risk management: The deregulated environment brings in its wake risks along with profitable
opportunities, and technology plays a crucial role in managing these risks. In addition to being
exposed to credit risk, market risk and operational risk, the business of banks would be
susceptible to country risk, which will be heightened as controls on the movement of capital are
eased. In this context, banks are upgrading their credit assessment and risk management skills
and retraining staff, developing a cadre of specialists and introducing technology driven
management information systems.

Corporate governance: Besides using their strengths and strategic initiatives for creating
shareholder value, banks have to be conscious of their responsibilities towards corporate
governance. Following financial liberalisation, as the ownership of banks gets broadbased, the
importance of institutional and individual shareholders will increase.

In such a scenario, banks will need to put in place a code for corporate governance for benefiting
all stakeholders of a corporate entity.

Misaligned mindset: These changes are creating challenges, as employees are made to adapt to
changing conditions. There is resistance to change from employees and the Seller market
mindset is yet to be changed coupled with Fear of uncertainty and Control orientation.
Acceptance of technology is slowly creeping in but the utilization is not maximised.
Competency Gap: Placing the right skill at the right place will determine success. The
competency gap needs to be addressed simultaneously otherwise there will be missed
opportunities. The focus of people will be on doing work but not providing solutions, on
escalating problems rather than solving them and on disposing customers instead of using the
opportunity to cross sell.

Investment in India - Banking System

The last decade witnessed the maturity of India's financial markets. Since 1991, every
governments of India took major steps in reforming the financial sector of the country. The
important achievements in the following fields is discussed under serparate heads:

Financial markets

Regulators

The banking system

Non-banking finance companies

The capital market

Mutual funds

Overall approach to reforms

Deregulation of banking system

Capital market developments

Consolidation imperative

Now let us discuss each segment seperately.


Financial Markets

In the last decade, Private Sector Institutions played an important role. They grew rapidly in
commercial banking and asset management business. With the openings in the insurance sector
for these institutions, they started making debt in the market.
Competition among financial intermediaries gradually helped the interest rates to decline.
Deregulation added to it. The real interest rate was maintained. The borrowers did not pay high
price while depositors had incentives to save. It was something between the nominal rate of
interest and the expected rate of inflation.

Regulators

The Finance Ministry continuously formulated major policies in the field of financial sector of
the country. The Government accepted the important role of regulators. The Reserve Bank of
India (RBI) has become more independant. Securities and Exchange Board of India (SEBI) and
the Insurance Regulatory and Development Authority (IRDA) became important institutions.
Opinions are also there that there should be a super-regulator for the financial services sector
instead of multiplicity of regulators.

The Banking System

Almost 80% of the business are still controlled by Public Sector Banks (PSBs). PSBs are still
dominating the commercial banking system. Shares of the leading PSBs are already listed on the
stock exchanges.

The RBI has given licences to new private sector banks as part of the liberalisation process. The
RBI has also been granting licences to industrial houses. Many banks are successfully running in
the retail and consumer segments but are yet to deliver services to industrial finance, retail trade,
small business and agricultural finance.

The PSBs will play an important role in the industry due to its number of branches and foreign
banks facing the constrait of limited number of branches. Hence, in order to achieve an efficient
banking system, the onus is on the Government to encourage the PSBs to be run on professional
lines.
Development Finance Institutions

FIs's access to SLR funds reduced. Now they have to approach the capital market for debt and
equity funds.

Convertibility clause no longer obligatory for assistance to corporates sanctioned by term-


lending institutions.

Capital adequacy norms extended to financial institutions.

DFIs such as IDBI and ICICI have entered other segments of financial services such as
commercial banking, asset management and insurance through separate ventures. The move to
universal banking has started.

Non-Banking Finance Companies

In the case of new NBFCs seeking registration with the RBI, the requirement of minimum net
owned funds, has been raised to Rs.2 crores.

Until recently, the money market in India was narrow and circumscribed by tight regulations
over interest rates and participants. The secondary market was underdeveloped and lacked
liquidity. Several measures have been initiated and include new money market instruments,
strengthening of existing instruments and setting up of the Discount and Finance House of India
(DFHI).

The RBI conducts its sales of dated securities and treasury bills through its open market
operations (OMO) window. Primary dealers bid for these securities and also trade in them. The
DFHI is the principal agency for developing a secondary market for money market instruments
and Government of India treasury bills. The RBI has introduced a liquidity adjustment facility
(LAF) in which liquidity is injected through reverse repo auctions and liquidity is sucked out
through repo auctions.
On account of the substantial issue of government debt, the gilt- edged market occupies an
important position in the financial set- up. The Securities Trading Corporation of India (STCI),
which started operations in June 1994 has a mandate to develop the secondary market in
government securities.

Long-term debt market: The development of a long-term debt market is crucial to the financing
of infrastructure. After bringing some order to the equity market, the SEBI has now decided to
concentrate on the development of the debt market. Stamp duty is being withdrawn at the time of
dematerialisation of debt instruments in order to encourage paperless trading.

The Capital Market

The number of shareholders in India is estimated at 25 million. However, only an estimated two
lakh persons actively trade in stocks. There has been a dramatic improvement in the country's
stock market trading infrastructure during the last few years. Expectations are that India will be
an attractive emerging market with tremendous potential. Unfortunately, during recent times the
stock markets have been constrained by some unsavoury developments, which has led to retail
investors deserting the stock markets.

Mutual Funds

The mutual funds industry is now regulated under the SEBI (Mutual Funds) Regulations, 1996
and amendments thereto. With the issuance of SEBI guidelines, the industry had a framework for
the establishment of many more players, both Indian and foreign players. The Unit Trust of India
remains easily the biggest mutual fund controlling a corpus of nearly Rs.70,000 crores, but its
share is going down. The biggest shock to the mutual fund industry during recent times was the
insecurity generated in the minds of investors regarding the US 64 scheme. With the growth in
the securities markets and tax advantages granted for investment in mutual fund units, mutual
funds started becoming popular.

The foreign owned AMCs are the ones which are now setting the pace for the industry. They are
introducing new products, setting new standards of customer service, improving disclosure
standards and experimenting with new types of distribution.
The insurance industry is the latest to be thrown open to competition from the private sector
including foreign players. Foreign companies can only enter joint ventures with Indian
companies, with participation restricted to 26 per cent of equity. It is too early to conclude
whether the erstwhile public sector monopolies will successfully be able to face up to the
competition posed by the new players, but it can be expected that the customer will gain from
improved service.

The new players will need to bring in innovative products as well as fresh ideas on marketing
and distribution, in order to improve the low per capita insurance coverage. Good regulation will,
of course, be essential.

Overall Approach To Reforms

The last ten years have seen major improvements in the working of various financial market
participants. The government and the regulatory authorities have followed a step-by-step
approach, not a big bang one. The entry of foreign players has assisted in the introduction of
international practices and systems. Technology developments have improved customer service.
Some gaps however remain (for example: lack of an inter-bank interest rate benchmark, an active
corporate debt market and a developed derivatives market). On the whole, the cumulative effect
of the developments since 1991 has been quite encouraging. An indication of the strength of the
reformed Indian financial system can be seen from the way India was not affected by the
Southeast Asian crisis.

However, financial liberalisation alone will not ensure stable economic growth. Some tough
decisions still need to be taken. Without fiscal control, financial stability cannot be ensured. The
fate of the Fiscal Responsibility Bill remains unknown and high fiscal deficits continue. In the
case of financial institutions, the political and legal structures hve to ensure that borrowers repay
on time the loans they have taken. The phenomenon of rich industrialists and bankrupt
companies continues. Further, frauds cannot be totally prevented, even with the best of
regulation. However, punishment has to follow crime, which is often not the case in India.

Deregulation Of Banking System


Prudential norms were introduced for income recognition, asset classification, provisioning for
delinquent loans and for capital adequacy. In order to reach the stipulated capital adequacy
norms, substantial capital were provided by the Government to PSBs.

Government pre-emption of banks' resources through statutory liquidity ratio (SLR) and cash
reserve ratio (CRR) brought down in steps. Interest rates on the deposits and lending sides almost
entirely were deregulated.

New private sector banks allowed to promote and encourage competition. PSBs were encouraged
to approach the public for raising resources. Recovery of debts due to banks and the Financial
Institutions Act, 1993 was passed, and special recovery tribunals set up to facilitate quicker
recovery of loan arrears.

Bank lending norms liberalised and a loan system to ensure better control over credit introduced.
Banks asked to set up asset liability management (ALM) systems. RBI guidelines issued for risk
management systems in banks encompassing credit, market and operational risks.

A credit information bureau being established to identify bad risks. Derivative products such as
forward rate agreements (FRAs) and interest rate swaps (IRSs) introduced.

Capital Market Developments

The Capital Issues (Control) Act, 1947, repealed, office of the Controller of Capital Issues were
abolished and the initial share pricing were decontrolled. SEBI, the capital market regulator was
established in 1992.

Foreign institutional investors (FIIs) were allowed to invest in Indian capital markets after
registration with the SEBI. Indian companies were permitted to access international capital
markets through euro issues.

The National Stock Exchange (NSE), with nationwide stock trading and electronic display,
clearing and settlement facilities was established. Several local stock exchanges changed over
from floor based trading to screen based trading

Private Mutual Funds Permitted


The Depositories Act had given a legal framework for the establishment of depositories to record
ownership deals in book entry form. Dematerialisation of stocks encouraged paperless trading.
Companies were required to disclose all material facts and specific risk factors associated with
their projects while making public issues.

To reduce the cost of issue, underwriting by the issuer were made optional, subject to conditions.
The practice of making preferential allotment of shares at prices unrelated to the prevailing
market prices stopped and fresh guidelines were issued by SEBI.

SEBI reconstituted governing boards of the stock exchanges, introduced capital adequacy norms
for brokers, and made rules for making client or broker relationship more transparent which
included separation of client and broker accounts.

Buy Back Of Shares Allowed

The SEBI started insisting on greater corporate disclosures. Steps were taken to improve
corporate governance based on the report of a committee.

SEBI issued detailed employee stock option scheme and employee stock purchase scheme for
listed companies.

Standard denomination for equity shares of Rs. 10 and Rs. 100 were abolished. Companies given
the freedom to issue dematerialised shares in any denomination.

Derivatives trading starts with index options and futures. A system of rolling settlements
introduced. SEBI empowered to register and regulate venture capital funds.

The SEBI (Credit Rating Agencies) Regulations, 1999 issued for regulating new credit rating
agencies as well as introducing a code of conduct for all credit rating agencies operating in India.

Consolidation Imperative

Another aspect of the financial sector reforms in India is the consolidation of existing institutions
which is especially applicable to the commercial banks. In India the banks are in huge quantity.
First, there is no need for 27 PSBs with branches all over India. A number of them can be
merged. The merger of Punjab National Bank and New Bank of India was a difficult one, but the
situation is different now. No one expected so many employees to take voluntary retirement from
PSBs, which at one time were much sought after jobs. Private sector banks will be self
consolidated while co-operative and rural banks will be encouraged for consolidation, and
anyway play only a niche role.
In the case of insurance, the Life Insurance Corporation of India is a behemoth, while the four
public sector general insurance companies will probably move towards consolidation with a bit
of nudging. The UTI is yet again a big institution, even though facing difficult times, and most
other public sector players are already exiting the mutual fund business. There are a number of
small mutual fund players in the private sector, but the business being comparatively new for the
private players, it will take some time.

We finally come to convergence in the financial sector, the new buzzword internationally. Hi-
tech and the need to meet increasing consumer needs is encouraging convergence, even though it
has not always been a success till date. In India organisations such as IDBI, ICICI, HDFC and
SBI are already trying to offer various services to the customer under one umbrella. This
phenomenon is expected to grow rapidly in the coming years. Where mergers may not be
possible, alliances between organisations may be effective. Various forms of bancassurance are
being introduced, with the RBI having already come out with detailed guidelines for entry of
banks into insurance. The LIC has bought into Corporation Bank in order to spread its insurance
distribution network. Both banks and insurance companies have started entering the asset
management business, as there is a great deal of synergy among these businesses. The pensions
market is expected to open up fresh opportunities for insurance companies and mutual funds.

It is not possible to play the role of the Oracle of Delphi when a vast nation like India is
involved. However, a few trends are evident, and the coming decade should be as interesting as
the last one.

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