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IMPACT OF NATIONALIZATION The quality of credit assets deteriorated, as the

process of sanctioning loans became more of amechanical process rather than an absolute creditassessment decision. Political interference also hasbeen an additional problem. There was very littleappraisal involved in the process of giving loans. Withsuch a process of lending, obtaining credit seemed tohave become the privilege of every borrower. Addedto this, were the credit facilities extended to the prioritysector at concessional rates. Such credit disbursals

that were done without proper post-sanctionsupervision led to the deterioration in the quality of theloan assets of the banks. Further, the subsidizedlending rates coupled with high levels of how yieldingSLR investments also adversely affected the

profitability of the banks.

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Yet another outcome of this rapid expansion has been

the squeeze on profitability of banks arising primarily due

to an increase in the fixed costs. With the proliferation ofbranches, there was also the resulting strain on the

managerial resources that resulted in enlarged

manpower resources. The operational costs of the banks

enhanced on account of the continuous servicing

requirements of the extensive branch network of the

banks.

While branch expansion was taken as a means to

achieve the goals of nationalization, the inherent evils of

haphazard expansion of branches crept into the bankingsystem. The existence of branches with higher operating

costs resulted in profit erosion, since in most of the

cases the branches added more costs than returns.

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WHY LIBERALIZATION?

The government of India framed its policies in the year1991-92, keeping in view the benefits of liberalization. It

was expected that in the process of opening its economy

to the outside world, increased competition could turn

the banks more efficient, bring about improvements and

ultimately benefit the customers.

Some of the root causes that were behind the dull

performance of banks prompted the initiation of the

banking sector reforms. Some of these causes were :

* Greater emphasis on directed credit ;

* Regulated interest rate structure ;

* Lack of focus on profitability ;

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* Lack of transparency in the banks balance sheets;

* Lack of competition ;

* Lack of grasp on the risks involved ;* Excessive regulations on organizations structure

and managerial resources ; and

* Excessive support from government.

The reforms were initiated with an aim to bring about aparadigm shift in the banking industry. Therecommendations made by the high level committee onthe financial sector reforms, chaired byMr. M. Narasimham, laid the foundation for the bankingsector reforms. The Committee, which was set up in1991, submitted its report in 1992. Another committeewas constituted again under the chairmanship ofMr. M. Narasimham, which submitted its report in 1998.

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These reforms tried to enhanced the viability and

efficiency of the banking sector. To tackle the internal

deficiencies of the sector, new norms relating toaccounting practices, prudential norms and capital

adequacy requirements were suggested. In order to

improve the external environment, the reforms aimed at

transforming the highly regulated environment into a

market oriented one.

While most of the recommendations made by the

committee in phase I have been accepted for

implementation, either in a single step or in phased

manner, some of them however are yet to beconsidered. The measures implemented so far that have

been given further, have revolutionized the structure and

operations of the banking industry.

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The liberalization of the Indian banking system had led to

the following improvements :

a. Lowered Entry Barriers : The Indian industry

apparently lacked a competitive environment,

thereby affecting its efficiency. To induce

competitiveness in this sector, the industry was

opened up to participation by private sector banksand foreign banks. Apart from allowing the Indian

banks to enter into joint ventures with foreign banks

(20 percent of equity), the foreign banks were also

permitted to set up their shop in India either as

branches or as subsidiaries. With this lowering ofentry barriers, many new players entered the

market.

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b. Deregulating the Interest Rates : One of the major

reform measures undertaken is the phased

deregulation of interest rates. As against theadministered interest rate regime, the banking sector

now operates in a deregulated environment. Directives

have been issued for total deregulation of the interest

rates on deposits and almost total deregulation of thelending rates. With this deregulation of interest rates,

banks now have gained flexibility in their operations.

Further, the concessional rates of interest in priority

sector lending have been withdrawn for borrowers of

higher credit amounts. The general rates of interestwill be applicable to these borrowers.

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c. Lowered Regulations : Branch licensing has been

abolished and branch expansion norms have been

relaxed enabling the banks to revamp theirorganizational structures. Banks have been given the

freedom to open or close branches as suitable to their

operations / viability.

Impac

t of Libera

liza

tionThe onset of liberalization has brought about changes

in the way the banks operate. Terms like customer

relationship, and competition among the existing

players and the new banks have taken the front seat.

The following are some of the changes seen in thebanking sector after liberalization.

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a. Technological Revolution : Information technology

has become an integral part of most of the banks

throughout the world. By leveraging this technology,banks are able to develop the necessary management

information system that would aid in taking scientific

decisions. Further, such information systems are also

being used to analyze the customer needs to innovate

their product portfolio accordingly.

Operational aspects and decision-making processes of

banks are closely linked to the speed and accuracy

with which information is collated and transmitted into

meaningful reports. More so, in the deregulatedinterest rate regime, quick investment and credit

decisions may also result in greater spreads to the

banks.

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To enable quicker decision-making and that too in ascientific manner, online inter-connectivity is most useful.

And the first step to this would be branch levelcomputerization. Most of the Indian banks have embarkedupon the process of computerizing their branches. Sincethe major part of the transactions arise at the branches,data processing and transmission will becomecomparatively easier if these transactions arecomputerized. Information technology has smoothenedback-office maintenance and improved the customerservice as well.

b. Better Customer Service : Information Technology inbanking business that is improving at a rapid pace, has amore visible impact on the customer service. It has not justresulted in product innovation, but it also enabling banks toredesign their traditional services into more sophisticatedproducts.

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c. Automated Teller Machines : These self-service

terminals, which are popularly known as ATMs, are cash

dispensers, which enable the customers to withdrawcash even if the bank is closed. Advanced features of

ATMs include withdrawals at other cities, use of credit

cards on ATMs, facilitating cheque and cash deposits

and acceptance of requests for cheque books and

account statements. Also, by mutual arrangement, one ATM terminal can be used as a cash dispenser for

various banks. This is known as the Shared Payment

Network System (SPNS). Further, these ATMs are set

up at locations other than bank branches. They are setup at public places like airports, railway stations,

shopping complexes, etc.

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d. Plastic Money : Plastic money in the form of credit

cards, debit cards and SMART cards has also

entered the Indian markets. While the credit and thedebit cards have been in the Indian markets for over

a decade, the SMART card is a relatively new

concept and has superior features. All the

transactions taking place on the credit / debit cards

will be recorded on the SMART card. The SMART

card reader of the bank will record the deposit

amount available in the SMART account of the

customers SMART card. Based on this, withdrawal

or deposit of funds can be taken up at any branch bythe SMART cardholder.

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e. Telebanking : In telebanking, bankers, with the help ofdedicated telephone lines, will provide service to theircustomers. With a telephone call, customers can get

the information they need which may relate to theirstatement of accounts, Forex rates or any otherinformation relating to their transactions. Telebankingis also being extended as a 24-hour service.

f. Electronic Funds Transfer (EFT) : Through thisprocess, banks enable their customers to remit fundsusing a computer terminal. Individuals and corporatescan transfer funds without leaving their premises. Thisfacility not only reduces the time lag in funds transfer,but also eliminates error prone paper work. The

prerequisite for this facility is that the concerned bankbranch has the network connection to receive andsend the coded funds transfer messages.

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g. Anywhere Banking : This service, which is offered

by few banks in India, facilitates the customer to

transact from any branch of the bank. The detailsregarding the customer are available in a central

computer linked to various branches. All the

information relating to the customer can be accessed

from this system.B

anks are now looking forward toRelationship Banking, which establishes a

relationship with the customer in such a way that all

the bank transactions of the customer domestic or

international and relating to the assets or liabilities

of the customer will be undertaken by a single bank.

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CHALLENGES AFTER NATIONALIZATION AND

LIBERALIZATION

In the aftermath of the nationalization ofBanks, increasing

use of technology, continuous mergers, modernizing

backroom operation and vigorous competition paved the

growth of the Indian banking system. By the early 90s, the

near monopoly of public sector banks faced competition

from the more customer-focused private sector entrants.

This competition demanded the older and nationalized

banks to revitalize their operations.

The year 1992 proved calamitous to the Indian bankingsystem owing to the scam-tainted stock. Large proportion

of household saving moved into the banking system, which

recorded an annual growth of 20 percent in deposits.

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But along with the continuous growth and modernization,several challenges still confront the banking sector. The

main challenges are the deployment of funds in qualityassets and the management of revenues and costs. Theproblems of NPAs (non-performing assets), and theoverall credit recovery system exist too.

The path of liberalization however has posed more

questions that remain to be answered. The data in Table1 reveals the growing volumes of NPAs that is indeedthreatening.

Considering these developments, the Reserve Bank ofIndia came up with a number of measures to control the

situation thereby reducing the percentage of non-performing assets against advances and leading tobetter management of banks. The following steps weretaken to reform bank operations.

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a. Prudential Norms : Prudential norms were introduced

to strengthen the banks balance sheets and enhance

transparency. These prudential norms which relate toincome recognition, asset classification, provisioning

for bad and doubtful debts and capital adequacy serve

three important purposes first, the income recognition

norms reflect a true picture of the income and

expenditure of the bank. Secondly, the assetclassification and provisioning norms help in assessing

the quality of the asset portfolio of the bank. Finally, the

capital adequacy which is based on the classification of

assets suggests whether the bank is in a viable

position to meet any adverse situations due to a

decline in the quality of its assets.

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Guidelines have been issued to identify non-

performing assets and classify them so that

room for subjectivity is eliminated. A time framewas provided to implement the same and

ensure that the system becomes compliant to

the rigorous guidelines. This move was

supported by capitalization of the public

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Box 1 : Narasimham Committee I Recommendations

Progressive reduction in pre-emptive reserves Cash Reserves

(CRR) and Statutory Liquidity Reserves (SLR)

Liberalization of branch expansion policy

Introduction of Prudential norms Capital Adequacy, Asset

Classification, Provisioning, Income Recognition.

Decrease in the emphasis laid on directed credit. Phasing out concessional rate of interest to priority sector.

Deregulation in the entry norms for private and foreign banks

33 percent reduction of government stake in banks

Greater emphasis on asset-liability management Setting up Asset Reconstruction Funds to takeover Non-

Performing Assets.

Consolidation of banking industry by merging strong banks.

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sector banks to ensure that over a given timeframe, they

could comply with the norms and yet strive to march

towards the future. These norms have been graduallytightened and beginning with the April 1998 Monetary

Policy, they were made applicable to the government

guaranteed advances as well. Provisioning will also have to

be made for advances which are both non performing and

performing.

To assess the capital adequacy ratio, weights were

assigned to the asset portfolio based on their riskiness. As

per the Narasimham Committee Report I, except for cash

and bank balances and SLR investments, all other assetswere assigned risk weights. However, with the Committees

second report, came the guidelines to assign risk weight to

the government approved securities.

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b. Capital Adequacy Requirements : Based on the

risk-weighted assets of the banks, the prudential

norms also prescribe the minimum capital to bemaintained. Initially, the international standard of 8

percent capital adequacy laid down by the Basle

Committee was accepted. However, a capital

adequacy of 9 percent is to be maintained by all theIndian banks with effect from 31 March 2000. These

high standards are expected to strengthen the

financial soundness of the banks, while continuing to

keep them in the line with International standards.

It is aimed to induce financial discipline into the

operations of the banks through these regulations.

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These regulations enhance transparency and

accountability in the operations of the banks thereby

compelling them pay greater attention to the quality oflending. In addition, these regulation conform to the

international accounting standards and would enable to

Indian players to operate in the global markets. Hence,

adherence to the guidelines would enhance the

sustainability of banks and make the competitive.

The reform measures were aimed at not only liberalizing

the regulation framework, but also to keep them in tune

with the international standard. And since the banks had

to move from a highly regulated environment toderegulated environment, some of the public sector

banks had to bear the orderal of reformaton.

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In an attempt to stabilize the banks positions during thistransition phase, the Government contributed capital to a

few among the weak nationalized to strengthen theircapital base. It also permitted some of these banks to setoff their accumulated losses against their capital. Allthese measures were taken in order to ensure that theIndian banking system reaches the global standards.

c. Additional Disclosure : From the year 2002 onwards,the notes to the balance sheets contain informationabout the movement of provisions for NPAs as well asthese held towards depreciation on investments. Non-SLF investments made through the private placement

route should disclose information about the compositionof the issuer and non-performing investments in a similarmanner. Efforts have been made to identify and monitorearly warning indicators of financial crises.

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The overall approach is to combine the use of micro-

prudential indicators with macroeconomic indicators in

order to develop a set of aggregate macro-prudentialindicators. This brings about a mix between bottom-up

and top-down assessment. As the methodology gets

refined and the indicators are stress-tested for predictive

power, financial stability surveillance will be significantly

improved. This process will involve greater transparency

and objectivity in the disclosure practices of banks.

Steps are taken to setup a Credit Information Bureau,

which collects and shares information on borrowers and

improves the credit appraisal of banks and financialinstitutions within the domain of the existing legislation.

The Bureau has been incorporated by, the State Bank of

India in collaboration with Housing Development Finance

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Corporation (HDFC) and foreign technology partners.

Collection and sharing of some items of information have

already been initiated. Steps are also being taken to collectand share information on private placement of debt under

the Bureau so that there is greater transparency in such

trades. The possibility of collecting and disseminating

information on suit-filed accounts by the Bureau (in place of

the Reserve Bank) is being explored by, a working groupconstituted for this purpose with representations from

across the financial system. The group will also examine

the prospects of online supply of information and the

processing of queries. A draft legislation covering various

aspects of information sharing, including issues relating torights, responsibilities, and privacy has been prepared,

which would considerably strengthen the functioning of the

Bureau.

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d. Benchmarking against International Standards :

Further to the above mentioned steps taken in

response to the challenges posed by liberalization,steps were also taken to benchmark the Indianbanking practices with the international standards. Forthis purpose, efforts are being made to ensure that theuniversally accepted standards and codes are

practiced. The leading international agencies like theWorld Bank and IMF are emphasizing on following theglobal standards. In India the process has begun withthe regulators and government concentrating onuniversally acceptable standards and codes for

benchmarking domestic financial systems. With thisthe private sector can also bring into its purview issuesrelating to market discipline, corporate governance,insolvency procedures and credit rights.

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The new standards and codes are not final goals but

instruments to enhance efficiency in financial intermediation

while ensuring financial stability as well. There are threelevels at which action is necessary, viz., legal, policy and

procedures, and market practices by participants. In

several areas, fundamental changes in the legal and

institutional infrastructure are pre-requisites. Since these

changes can influence the socio-cultural as well as political-economic culture to a great extent, appropriate adoption

and some prioritization in implementation are unavoidable.

In several areas, the issues are of a technical nature.

Accordingly, the Standing Committee on International

Standards and Codes, setup in December 1999,

constituted ten Advisory Groups comprising eminent

experts, generally non-official, to

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bring objectivity and experience into studying the

applicability of relevant international codes and

standards to each area of competence. The AdvisoryGroups have submitted their reports. They have set out

a road map to implement appropriate standards and

codes in the light of existing levels of compliance, the

cross country experience, and the existing legal and

institutional infrastructure.

Increasing Risks in Banking Sector

Risks manifest themselves in many ways and the risks in

banking are a result of many diverse activities, executedfrom many locations and by numerous people.

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Box 2 : Narasimham Committee II Recommendations

This Committee constituted in January 1998 submitted

its report in April 1998. The major recommendationswere :

Capital adequacy requirements should take into

account market risks also.

In the next three years, entire portfolio of government

securities should be marked-to-market.

Risk weight for a government guaranteed account must

be 100 percent.

CAR to be raised to 10 percent from the present 8

percent ; 9 percent by 2000 and 10% by 2002.

An asset should be classified as doubtful if it is in the

sub-standard category for 18 months instead of the

present 24 months.

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Banks should avoid ever greening of their advances.

There should be no further re-capitalization by the

government.

NPA level should be brought down to 5 percent by 2000

and to 3 percent by 2002.

Banks having high NPAs should transfer their doubtful

and loss categories to ARCs, which would issue

government bonds representing the realizable value ofthe assets.

Move towards international practice of income

recognition by introducing the 90-day norm instead of

the present 180 days. A provision of 1 percent on standard assets is required.

Government guaranteed accounts must also be

categorized as NPAs under the usual norms.

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Banks should update their operational manuals, which

should form the basic document of internal control

systems.

Institute an independent loan review mechanism

especially for large borrowal accounts to identify

potential NPAs.

Recruitment of skilled manpower directly from the

market to be given urgent consideration.

Rationalize staff strength ; introduce an appropriate

VRS.

A weak bank should be one whose accumulated losses

and net NPAs exceed its net worth or one whoseoperating profits less its income on recap bonds is

negative for 3 consecutive years.

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Box 3 : Type of Risks

Based on their origin and nature, risks are classified into various

categories. The most prominent financial risks to which the

banks are exposed are :

Interest Rate Risk : Risk that arises when the interest income /

market value of the bank is sensitive to the interest rate

fluctuations.

Foreign Excha

nge / Currenc

y Risk : Risk that arises due tounanticipated changes in exchange rates and becomes relevant

due to the presence of multi-currency assets and / or liabilities in

the banks balance sheet.

Liquidity Risk : Risk that arises due to the mismatch in the

maturity patterns of the assets and liabilities. This mismatch maylead to a situation where the bank is not in a position to impart

the required liquidity into its system surplus / deficit cash

situation. In the case of surplus situation, this risk arises due to

the interest cost on the ideal funds. Thus idle funds deployed at

low rates contribute to negative returns.

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Credit Risk : Risk that arises due to the possibility of a

default / delay in the repayment obligation by the borrowers

of funds.

Contingency Risk : Risk that arises due to the presence of

off-balance sheet items such as guarantees, letters of

credit, underwriting commitments, etc.

As a financial intermediary, banks borrow funds and landthem as a part of their primary activity. This intermediation

activity of banks exposes them to a host of risks (See box

Type of Risks). The volatility in the operating environment

of banks will aggravate the effect of the various risks. The

box discusses the various risks that arise due to financialintermediation and by highlighting the need for asset

liability management it discusses the Gap Model for risk

management.

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CONCLUSION Indian banking has seen a great shift in the method of its

operations along with its focus. Techniques like customerrelationship management, unknown to the Indian BankingSystem till several years ago, have now acquired specialimportance. Several scams that have occurred in the bankingsector in the recent past, have to a certain extent evenquestioned the creditability of banks in maintaining savings

deposit accounts. However, different steps taken by the RB

Iand the Government of India have helped to restore the confidence of the public in the banks. Nationalized banks arestill considered the safest avenues to save money. Thebankruptcy of co-operative banks as Krushi Bank, CharminarBank and the involvement of Madhepura Mercantile Co-operative Bank in security scams, raise serious questionsabout the purpose behind their establishment. These eventshave compelled intervention of Reserve Bank of India andGovernment of India. A proper understanding andimplementation of Asset-Liability Management may offersolutions to some of the problems faced by the banks andconfidence in the people.

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COMMERCIAL BANKS

Balancing profitability with Liquidity

management: commercial banks ordinarilyare simple business or commercial

concerns which provide various types of

services to customers in return for

payment in one form or another, such asinterest,discounts,fees,commission and so

on. Their objective is to make profit.

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In India especially, banks are required to

modify their performance in profit making if

that clashes with their obligations in such

areas as social welfare, social justice, and

promotion of regional balance in

development. In any case, banks in

general have to pay much more attentionto balancing profitability with liquidity. It is

true that all business concerns face

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Liquidity constraint in various areas of their

decision making and therefore they have

to devote considerable attention to liquidity

management. But with banks, the need for

maintenance of liquidity is much greater

because of the nature of their liabilities.

Banks deal in other peoples money, asubstantial part of which is repayable on

demand. That is why for banks, unlike

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Other business concerns, liquidity

management is as important as

profitability management. This is reflected

in the management and control of

reserves of commercial banks.

Management of reserves

Creation of credit

Basis and process of credit creation