Future of Banking in India – Changing Imperatives    

RISK MANAGEMENT AND BASEL II

The future of banking will undoubtedly rest on risk management dynamics. Only those banks that have efficient risk management system will survive in the market in the long run. The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution.

Although capital serves the purpose of meeting unexpected losses, capital is not a substitute for inadequate decontrol or risk management systems. Coming years will witness banks striving to create sound internal control or risk management processes. With the focus on regulation and risk management in the Basel II framework gaining prominence, the post-Basel II era will belong to the banks that manage their risks effectively. The banks with proper risk management systems would not only gain competitive advantage by way of lower regulatory capital charge, but would also add value to the shareholders and other stakeholders by properly pricing their services, adequate provisioning and maintaining a robust financial structure.

‘The future belongs to bigger banks alone, as well as to those which have minimised their risks considerably.’

CONSOLIDATION

Consolidation, which has been on the counter over the last year or so, is likely to gather momentum in the coming years. Post April 2009, when the restrictions on operations of foreign banks will go, the banking landscape is expected to change dramatically. Foreign banks, which currently account for 5% of total deposits and 8% of total advances, are devising new business models to capture the Indian market. Their full-fledged entry is expected to transform the business of banking in many ways, which would be reflected in terms of greater breadth of products, depth in delivery channels and efficiency in operations.

Thus Indian banks have less than three years to consolidate their position. Despite the stiff resistance from certain segments, consolidation holds the key to future growth. This view is underpinned by the following: ► Owing to greater scale and size, consolidation can help save costs and improve operational efficiency. ► Banks will also have to explore different avenues for raising capital to meet norms under Basel-II

► Owing to the diversified operations and credit profiles of merging banks, consolidation is likely to serve as a risk-mitigation exercise as much as a growth engine.

Though there is no confirmation yet, speculative signals arising from the market point to the prospect of consolidation involving banks such as Union Bank of India, Bank of India, Bank of Baroda, Dena Bank, State Bank of Patiala, and Punjab and Sind Bank. Further, the case for merger between stronger banks has also gained ground — a clear deviation from the past when only weak banks were thrust on stronger banks. There is a case being made for mergers between banks with a distinct geographical presence coming together to leverage their respective strengths.

GLOBALIZATION/ OVERSEAS EXPANSION

Growing integration of economies and the markets around the world is making global banking a reality. The surge in globalization of finance has already begun to gain momentum with the technological advancements which have effectively overcome the national borders in the financial services business. Widespread use of internet banking will widen frontiers of global banking, and make marketing of financial products and services on a global basis possible. In the coming years globalization will spread further on account of the likely opening up of financial services under WTO. India is one of the 104 signatories of Financial Services Agreement (FSA) of 1997. This gives India’s financial sector including banks an opportunity to expand their business on a quid pro quo basis.

As per Indian Banks' Association report ‘Banking Industry Vision 2010’, there would be greater presence of international players in Indian financial system and some of the Indian banks would become global players in the coming years. So, the new mantra for Indian banks is to go global in search of new markets, customers and profits.

TECHNOLOGY

There is an imperative need for not mere technology upgradation but also its integration with the general way of functioning of banks to give them an edge in respect of services provided to their constituents, better housekeeping, optimizing the use of funds and building up of MIS for decision making, better management of assets & liabilities and the risks assumed which in turn have a direct impact on the balance sheets of banks as a whole. Technology has demonstrated potential to change methods of marketing, advertising, designing, pricing and distributing financial products and services and cost savings in the form of an electronic, self-service product delivery channel. These challenges call for a new, more dynamic, aggressive and challenging work culture to meet the demands of customer relationships, product differentiation, brand values, reputation, corporate governance and regulatory prescriptions. Technology holds the key to the future success of Indian Banks.

Internet, wireless technology and global straight-through processing have created a

paradigm shift in the banking industry. The explosive growth of both the Internet and mobile and wireless technology is revolutionizing the way the financial industry conducts business. The overall wireless technology market is expected to grow profoundly in the coming years.

REGULATIONS

The RBI's approval for banks to raise funds abroad through innovative capital instruments holds great significance. Such fund-raising, which includes preference shares, will, however, not just substitute equity; it could have unintended consequences on the strategies of banks and their profitability. While the cost of raising monies through such instruments is likely to be higher (close to 10 per cent), the consequent higher leverage on equity funds is likely to result in expansion of return on net worth. This is because the same amount of capital supports a higher volume of business, generating higher profits. Banks are likely to be able to raise long-term preference shares at coupon rates between six per cent and eight per cent. The positive impact on bank profitability could thus be significant. Preference capital can be used as the currency for acquisition. The advantage for public sector banks is that they no longer need to bother about government stake falling below 51 per cent. Banks such as Dena Bank, Oriental Bank of Commerce and Andhra Bank are most likely to benefit from this move.

SKILLED MANPOWER

There will be a sea change for employees too. Secure jobs will be replaced by contractual appointments, for a specified period of time. The unions will merge into the shadows and bank managements will turn effective. As a result there will be swifter turn over of personnel in banks. But at the same time, skilled personnel from other disciplines will enter banks in increasing numbers. Factors like skills, attitudes and knowledge of the human capital play a crucial role in determining the competitiveness of the financial sector. The quality of human resources indicates the ability of banks to deliver value to customers. Capital and technology are replicable but not the human capital which needs to be valued as a highly valuable resource for achieving that competitive edge.

Business model, which comprises a comprehensive range of business solutions delivered through a unique balance of portfolio and relationship management must be incorporated.

FUTURE CHALLENGES & SUGGESTIONS

Challenges ►Competition ►Customer Retention

►Globalization ►Shrinking Margin

Suggestions ►Strong In-house research & market Intelligence ►Focused marketing- Focus on region-specific campaigns rather than national media campaigns

The growth of the retail financial services sector has been a key development on the market front. Indian banks (both public and private) will not only be keen to tap the domestic market but also to compete in the global market place. New foreign banks will be equally keen to gain a foothold in the Indian market.

CONCLUSION:

What will the future of Indian banking and insurance look like? Will the reform in banking and insurance sectors face the same fate as in power and telecom? It is increasingly evident that the economy offers opportunities but no security! Therefore, the future will belong to those who develop good internal controls, checks and balances and a sound market strategy. Business Growth, Cost Efficiency and Evolution are therefore regarded as key drivers which will have to be addressed.

Future of banking and insurance

R. Parthasarathy

REFORMING the financial sector is central to second-generation reforms. This covers three important segments -- banking, insurance and the capital market. Some reform has already taken place in the capital market, though strengthening the institutional m echanism to prevent unethical practices is receiving the Government's attention. The latest to be opened up for private investment, including foreign direct investment, is the insurance sector.

On a rough reckoning, commercial bank deposits account for 25 per cent of GDP and credit extended by banks may be 15 per cent of GDP. This leaves out transactions by industrial financial institutions, non-banking financial companies, cooperative banks, d eposits in public provident funds treasury payments some of which may be agency functions of the banks. Thus, regular bank credit transactions alone account for a substantial percentage of GDP by way of servicing economic activities.

A gradual convergence is taking place in the banking and insurance sectors. Several major banks are floating subsidiaries to enter both life and non-life insurance businesses. Some of them are looking at niche markets such as corporate insurance.

There a re reports that Tata-AIG will be launching ``Mobile Claims Service'' in four metros and Bangalore and Hyderabad for quick settlement of customer claims. SBI, in collaboration with Cardiff of France, is planning to enter life insurance.

Features common to both sectors are financial discipline, regulatory framework and prudential norms in investment management. Given the kind of convergence taking place, there is need for closer institutionalised cooperation among the RBI, Insurance Regu latory and Development Authority of India (IRDA) and the Securities Exchange Board of India. A single regulatory authority is unfeasible. This has also been the experience of Canada, the US, the UK and Germany.

The banking sector has been undergoing reforms for over a decade now based largely on the report of the Narasimham Committee on Bank Reforms. Considerable progress has been made in the gradual reduction of non-performing assets of banks which stood at al arming 12-15 per cent six or seven years ago. It is now around 7 per cent on net basis.

Reform of the insurance sector began with the decision to open up this sector for private participation with foreign insurance companies being allowed entry with a maximum of 26 per cent capital investment. The major step, however, was the passing of the Insurance Regulatory Authority Act, 1999 on April 20, 2000. With this, 14 companies in life insurance and nine in non-life insurance have been given permission by the IRDA so far, and within the next one year this figure may go up to 30.

Innovative products and ethics in marketing

The future will offer a wider choice for policy-holders, with innovative products to suit particular needs. But as often is said, insurance policies are sold and not bought. This means ethical marketing practices must be strictly observed and enforced. D eceptive packaging of policies or misleading advertisements should attract stern penalties. This is one area of focus for corporate governance and insurers must self-regulate this activity by evolving a code of ethics in marketing.

Some of the major areas where IRDA has made regulations or issued guidelines are analysed below:

* Actuarial report, abstract and role of appointed actuary: This is a key reporting document which, if truthfully executed, will bring out the true state of affairs of the business. In the life insurance business, a key person in the system of supervisio n is the appointed actuary for which a separate provision exists in IRDA regulations.

The actuary has a wide range of responsibilities, especially to determine reserves, and to ensure the continuing viability of the insurance products and projecting a true and fair picture of the company's financial affairs. This will, thus, constitute a major area of corporate governance.

* Obligations of insurers to rural and social sectors: A minimum percentage starting from 5 per cent and going up to 12 per cent, of total insurance must be set apart for rural and social sectors, with stipulation on the number of lives to be insured in order to increase penetration. This should motivate insurers to innovate products best suited for weaker sections of society and the rural segment of the population.

Under Indian conditions, the innovative capability of the insurer will be fully tested in coming up with suitable products to suit different socio-economic strata. Currently, benchmark statistics on claims settlement or cost/benefit analysis may not be r eadily available. But considering the gradual rise in rural incomes and existence of insurable risks, the rural sector will provide greater opportunities.

* Insurance advertisements and disclosures: This is an important area for sharing information, not only with the insurance regulatory authority but also policy-holders and share-holders. This will be a key area of corporate governance. The IRDA has guide lines to help insurance companies adhere to norms.

* Licensing of insurance agents: In the insurance business, most selling takes place through tied agents, and companies tend to launch lavish and aggressive campaigns that raise commissions and selling costs. There could be a multiplicity of distribution channels -- bankassurance, corporate bodies and independent brokers. The agent's role in life insurance is particularly important.

In the US, a tied agency is generally the norm. Tied agents, being sales persons for individual companies, are governed by company standards and products on offer, while an independent broker may have wider access to products of different companies, depe nding on specific consumer needs. Also, competition among companies may not be only in respect of services offered, but also with reference to special features of products.

Currently, in India with LIC and the erstwhile subsidiaries of General Insurance Corporation (GIC) having near monopoly position, there can only be tied agencies. But what about the future? With the emergence of several new players, should there be tied agents and brokers with multiple affiliations? These issues need to be considered.

* General insurance -- reinsurance: General insurance in India is more focussed on industry and commercial enterprises with emphasis on fire, theft risks and property damage. While the four subsidiaries of GIC will focus on general insurance, GIC itself will function as a reinsurer under the new dispensation. Despite the vast untapped market potential, health insurance has not attracted as much attention as other forms of business. Perhaps, some life insurance companies may have plans of part coverage o f health under their schemes. Vehicle insurance is another major area of general insurance activity.

Marine insurance will increasingly become important, but at present, there are established international players in this field, such as Lloyds, UK.

Technology brings its own demands. For instance, with the emergence of information technology, new areas of risk coverage will come to the fore. Also, product liability and professional risk coverage schemes which are relatively new in the Indian context may emerge as insurable risks. Proper risk analysis and internal guidelines within companies in regard to these new forms of business will be important and necessary functions of corporate governance.

* Assets, liabilities and solvency margin of insurers: Valuation of assets and provision for liabilities should be done realistically. International practices in this matter differ widely. Unrealised investment gains may not be reflected in the profit-an d-loss account and, thus, cannot form the basis of determining distributable profits. This is a prudent and one conservative accounting practice. On the contrary, in the UK,

companies have the freedom to choose market value, historical cost or a value be tween the two. The conservative approach might seem better suited to the Indian conditions, given the volatility of investment markets and the nascent state of the insurance industry under competitive conditions. The IRDA, according to press reports, rec ently relaxed the norms for investments for new entrants in rated securities. The Regulator has also permitted `+A' rated instruments instead of the earlier `AA'.

The problem of availability of instruments with higher ratings must be recognised at a time when the capital market is witnessing listless conditions. The question that needs to be addressed is to what extent investment in offshore debt instruments may b e allowed, and what should be the criteria for such investments? Already, mutual funds are allowed to invest in offshore instruments.

This also stresses the need for more prudent management of investments of funds. In India, general insurance companies have more freedom of investment of surplus funds. Forty five per cent of their investments, compared to 75 per cent in the case of LIC, come under ``directed investments''. On the contrary, control of expenditure is better in life insurance, compared to general insurance, mainly because leakages in general insurance are higher. Despite such differences, the free reserve position of LIC is poor.

Regarding solvency margins, there are two approaches. One is fixing of premiums at levels that may be adequate to pay for future claims and avoid insolvencies. The other approach is solvency monitoring. Normally, one would prefer the second method as it leaves flexibility in the hands of insurers to fix premia for specific policies, particularly in the context of emerging competition and product differentiation.

* Condition of service of officers and other employees: Manpower planning and training will be crucial to successful operation of business, particularly in the competitive environment. Of the population of more than one billion, those covered by some for m of insurance or the other may be around 40 million. According to one estimate, the potential market is about 200-250 million, with an annual growth rate of 15 per cent.

* Insurance surveyors and loss assessors: Insurance surveyors and loss assessors are an important link in the insurance business, particularly in general insurance, where assessing the insurable risk and premium of the property to be insured and, subsequ ently, in the event of a claim settlement arising, assessing the amount of settlement may determine the loss or gain to the insurer from such a transaction.

What about the future?

What will the future of Indian banking and insurance look like? Will the reform in banking and insurance sectors face the same fate as in power and telecom? It is increasingly evident that the economy offers opportunities but no security! Therefore, the future will belong to those who develop good internal controls, checks and balances and a sound market strategy.

The finance ministry has a new incumbent and the hope all round seems to be that he will try and improve the feel good factor. While wishing the new finance minister the best in his endeavour, I would request him to resist the temptation of tinkering with the financial

system or key organisations in it with a view to merely creating an illusion of economic well being. The tendency to make marginal changes in a random manner is pervasive in this country resulting in creating incomplete systems and inchoate organisations. The financial sector is a case in point with a large number of knee-jerk reactions to scams or systemic failures. It is important to understand that sometimes inaction may be better than thoughtless hasty action. This applies as much to organisational change as it does to sector level changes.

The financial sector has witnessed changes in many respects. Banking has seen many changes in the last two decades, as has the mutual fund business. During the first three decades after independence, the financial sector and changes in it were largely dominated by SBI, IDBI, IFCI, UTI, ICICI, and LIC but the last two decades saw a significant contribution by many other players, smaller in size, but faster on their feet. Each one of these large players was created with very specific mandates, but with sector-wide responsibilities. For example formation of SBI was the result of the Rural Credit Survey Committee recommendation to create an entity that among other things, would help the government in stimulating banking in the entire country. Similarly, the UTI was created in 1964 with the explicit objective of stimulating investment in the stock market. In other words, these organisations were created with specific purposes and a vision for the future. They have significantly served the purposes that drove them all these years, and delivered on the agenda set for them. The present day financial sector has been built on the achievements of these organisations. However, in the last few years, we see organisations like SBI and UTI endeavouring to compete with every player in the market. As a consequence, these organisations are trying to become everything to everybody. The negative image associated with a public enterprise has only added to their attempt to emulate private enterprise behaviour. Survival has become the objective of these pioneers. In sum, these organisations are fast losing their initial identity without gaining a new one! These organisations are trying to respond by tinkering with their organisation design or by changing the ownership pattern. Such interventions are likely to be inappropriate given the status of these organisations. A comprehensive relook at the existence of these organisations is an imperative. They will have to introspect on their relevance in the present context. For example, SBI will have to contemplate on the role it can play in the market given the state of the market today and a desirable state in the future. Similarly, UTI may have to examine its role in the mutual fund sector.

Organisations, which have played defining roles in economies, have often found themselves at such crossroads because they reach there first. The genius of the organisation is in identifying the moment as such and in reinventing itself to play a similar pivotal role again although in a different context. AT&T was one such organisation, which during the early seventies went through an elaborate exercise of reinventing itself for the future state of communications business that it envisioned. The task was not just about being prepared for the future but about preparing to shape the future of the industry. The major players of the financial markets in India will have to do something similar; they need to envision the desirable future state of the market and define their role in shaping the future. This would mean playing a pioneering role once again in a new context; any other role would probably be insignificant for these

organisations. The finance ministry as the de facto owner of these organisations needs to encourage their managements to undertake this critical task immediately.

Wondering about the future of the Indian economy? Is the boom in the job market superficial? Well, nobody has an answer to that but what we know is that currently India is short of a million employees in Financial services and IT sectors.

The Retail Banking is witnessing a 30 % Growth in India, with the top banks experiencing a rise as much of 70%. Insurance is growing by 50%, Mutual Funds growing by 33%, Credit Cards by 35%. Today Banking sector employs about 900000 people and with full reforms it can employ 15, 00,000 people. However one of the crucial impediments to growth for this sector is the acute shortage of manpower talent of this specific nature.

 Further, India can grab jobs from other countries. A.T. Kearney Inc. predicts that half a million financial-services jobs will go offshore to India by 2008. The employers are hunting for skilled employees creating great opportunities for young graduates. In the wake of a severe manpower shortage, India is witnessing the highest growth rate in the salaries in the world! According to the 2006 Salary Guide issued by Kelly Services India, the country has the highest average salary increase at 13.9 %. Wage rises in Hong Kong are forecast at 1.5%, while those in Japan, Taiwan, South Korea and Malaysia are likely to be between 2% and 3.5%.Indeed, an acute manpower shortage especially in the finance and analytics sector has resulted in a peculiar situation of unrelated sectors competing with one another.

For example, software giant Infosys chief Nandan Nilekani recently said the IT industry is facing tough recruitment competition from the financial services sector. Nilekani said that the two sectors are driving up the demand for entry-level people, though IT continues to hire the largest number of new employees. "With the industries competing for the best talent, financial services could offer a slightly higher wage to grab them,'' Nilekani said.This can be related to the major hike in the salary packages at B-Schools in the last couple of years. More dramatic demand consequences can be seen at the campuses of Economics schools around the country, that produce specialists aptly suited for the lucrative Finance Sector. The average salary packages at Economics schools like Delhi School of Economics & Indian Statistical Institute have increased by 100% in the last 5 years.