STRUCTURE OF THE BANKING INDUSTRY

According to the RBI definition, commercial banks which conduct the business of
banking in India and which (a) have paid up capital and reserves of an aggregate real
and exchangeable value of not less than Rs 0.5 mn and (b) satisfy the RBI that their
affairs are not being conducted in a manner detrimental to the interest of their
depositors, are eligible for inclusion in the Second Schedule to the Reserve Bank of
India Act, 1934, and when included are known as ‘Scheduled Commercial Banks’.
Scheduled Commercial Banks in India are categorized in 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) Nationalised Banks, (iii) Regional Rural Banks, (iv) Foreign
Banks and (v) Other Indian Scheduled Commercial Banks (in the private sector). All
Scheduled Banks comprise Schedule Commercial and Scheduled Co-operative Banks.
Scheduled Cooperative banks consist of Scheduled State Co-operative Banks and
Scheduled Urban Cooperative Banks.

INDIAN BANKING AND INTERNATIONAL TRENDS

When compared to other emerging markets, the growth of Indian banking has been
impressive and compares favorably on several counts. A recent study by Bank for
International Settlements on the progress and the prospects of banking systems in
emerging countries highlights the following features of the performance of Indian
banks:

• Average growth rate of real aggregate credit in India rose from 6.1%
during the period 1995- 99 to 14.6 % in 2000-04.
• The average growth rate of real aggregate credit in India during 2000-04
in India is higher as compared to major countries and regions in the emerging
markets, such as China (13.3%), Other Asia (4.7%), Latin America (4.5%), and
Central Europe (9.6%).
 • Commercial banks in India account for a major share of the bank credit
(97%) as compared to Latin America (68%), Other Asia (74%) and Central
Europe (83%).
• Real bank credit to the private sector has shown sustained growth in
India, and has moved from 3.9% a year in 1990-94 to 6.9% a year in 1995-99 to
13.5 % a year in 2000-04. In 2005, real bank credit to the private sector in India
showed a growth of 30% year-on-year as against 9.4% in China and 15.8% in
emerging markets.
• In India, during the period 1999 and 2004, non-performing loans as a
percentage of total commercial bank assets came down from 6.1% to 3.3%,
capital asset ratios moved up from 11.3% to 12.9% and operating costs as a
percentage of total assets reduced from 2.4% to 2.3%. NPAs in China in 2004
stood at 6%.
• In India, return on assets of banks during the period 1999-2004 moved up
from 0.4% to 1.1%, and return on equity from 8.5% to 20.9% where as in China
the former rose from 0.1% to 0.3%.

The major trends which are emerging in Banking Business

Indian banking, in addition to improvements in performance and efficiency, has also
experienced significant changes in the structure of asset and liabilities. The major
changes on the liabilities side include relatively higher growth of demand deposits over
time deposits, and also, within time deposits, greater preference for short term over the
longer term deposits. The share of demand deposits in total deposits increased from
14.7% in FY01 to 17% in FY06. The share of short term deposits in total time deposits
increased from 43.8% in FY00 to 58.2% in FY06. The narrowing of interest rate spread
between short and long term deposits has reduced the preference for long term deposits.

Banks are moving away from investments to loans due to more lending opportunities
offered by the higher economic growth. The rate of bank credit growth which was at
14.4% in FY03 rose sharply to reach 30% each in the FY05 and FY06. Bank credit has
picked up momentum on the back of rising growth of real economy. A period of low
interest rates induced banks to shift their preference from investments to advances,
which led to the share of gross advances in total assets of all commercial banks reaching
54.7% in FY06 from 45% in two years prior to that.

The sectors towards which the bank credit was directed has also shown significant
changes. Retail loans witnessed growth of over 40% in the last two years, and began
driving the credit growth to a significant extent. Retail loans as a percentage of Gross
Advances rose from about 22% in FY04 to 25.5% in FY06. Within the retail loans,
housing segment showed the highest growth of 50% in FY05 and 34% in FY06. As per
the RBI data, banks direct exposure to commercial real estate more than doubled in
FY06.

Despite sharp rise in the credit growth, improved risk management processes and
procedures of banks contained the surge in bad debts which is evident from the lower
levels of incremental nonperforming assets reported by the banks as also the rise in the
proportion of standard assets. Further improvement in risk management systems could
provide banks with more opportunities in expanding credit and pursuing higher levels of
growth in retail lending.

RATING OF BANKS
RBI has subjected banks to ratings under capital adequacy, asset quality, compliance, and
system (CACS); and capital adequacy, asset quality, management, earnings, liquidity,
and systems (CAMELS) models for differentiating supervisory priorities. When reforms
were first introduced under recommendation of the Narasimham committee (I), the 27
(then28) PSBs were placed under A, B, and C categories; i.e., sound banks, banks with
potential weakness, and sick banks, respectively. Accordingly, recapitalization and
restructuring were carried out for B and C categories. For individual ratings by
international rating agencies, a bank is assessed as if it were entirely independent and
could not rely on external support. The ratings are designed to assess a bank’s exposure
to risks, appetite for risks, and management of risks. Any adverse or inferior rating is an
indication that it may run into difficulties such that it would require support. Such credit
rating announcements ignore the public sensitivity to which the banking system is
constantly exposed to the individual and support ratings. The public expects banks to try
to anticipate changes, recognize opportunities, deal with and manage risks to limit losses,
and create wealth through lending. While the best banks may always play a super-safe
role by confining operations to choice centers and business segments, banks in India are
expected to operate on a high-risk plane. As such, the Government should support banks
even during stages when they are nudged to offer equity to the public.

Opportunities
The opportunities for banking are enormous if the industry can transform and adapt to the
21st century. Unfortunately little evidence exists that such a transformation will be led
from within the banking industry. Therefore banking may be subject to similar threats
that have disrupted mature markets in the past. The pace of change in society and the
growing power of consumers enabled by global technology changes will present serious
challenges to the status quo in financial services.
The very conception of currency, as it has existed for centuries as paper tender, may be
dramatically influenced by the secure mobile devices that people already carry.
Technical advances have been constrained by a variety of industry forces with vested
interests in the status quo that combine to stall innovation. A critical mass of new
technical capabilities are gaining momentum, and the profit pools in banking are so large
that it is inevitable that new companies will form to attack the banking industry. These
companies will seize the opportunity to provide superior value that is aligned with the
new reality of customer expectations and new technical capabilities.

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
seller 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 batting 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 this 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.

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
maximized.

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.

Strategic options with banks to cope with the challenges

• Leading players in the industry have embarked on a series of strategic and tactical
initiatives to sustain leadership. The major initiatives include:
• Investing in state of the art technology as the back bone to ensure reliable service
delivery
• Leveraging the branch network and sales structure to mobilize low cost current
and savings deposits
• Making aggressive forays in the retail advances segment of home and personal
loans
• Implementing organization wide initiatives involving people, process and
technology to reduce the fixed costs and cost per transaction
• Focusing on fee based income to compensate for squeezed spread, (e.g. CMS,
trade services)
• Innovating Products to capture customer ‘mind share’ to begin with and later the
wallet share
• Improving the asset quality as per Base II norms