RISK, THE BUSINESS DRIVER IN BANKS

Bio

INTRODUCTION

Banking business is run on the basic premise that not all the depositors will ask for their money back fully at the same time and there will always be a cash flow mismatch arising out of primarily borrowing (Deposits) short and lending (Loans) long. In this process the spread has to take care of various risks, which are broadly known as Credit Risk, Market Risk inclusive of Liquidity Risk and Operational Risk, besides generating profit for the shareholders and for the business growth. Always Risk is subjective and perhaps may also be, more often than not, personal rather than intrinsic to the event, as one may be right in the long term, but wrong in the short term and vice-versa may also be true.

This book is brought out primarily with the aim of familiarizing the risk concepts among the banking fraternity. Banks are the vital part of economy in any part of the world and the essence of banking lies in the management of risk associated with the banking activities. An attempt is made to be comprehensive in identification, management and mitigation of risk running across the banking functions. In the definition of risk being the uncertainty of event resulting in loss or damage, emphasis is on the word uncertainty, which is certain. But volatility, by itself alone, is not a perfect measure of risk. This book is slated to enable the readers to acquire a firm grip on the fundamentals of and foundations on risk management, sans analytical tools. The objective is to sensitise the banking and finance professionals on the subject of Risk having immense potentials & huge impact in the financial market. Risk tolerance is totally a behavioral aspect of individuals, emotional biases such as regrets, self-controls, loss aversions, hind-sights, etc. to risky situations more often than not diverge from cognitive assessment of such risk.

All the bankers need to stand up to the Risk and also romance the same as banker cannot wish it away, for taking risk is the prime activity of banker, akin to fish taking to and swimming along water, without which it cannot survive. When the size of an entity is big and is highly leveraged, during the down-turn, it can bring down the whole system. It may be felt that when measuring risk is so imprecise and imperfect, why to bother about it. But, essentially, banks are in the business of taking conscious risks to generate return using some plain vanilla and some sophisticated instruments, both of which are prone to risks. Risk, a constantly evolving subject, is nothing but fearing about the fear, which otherwise is known as risk phobia. Hence the concepts and methodologies for evaluation of risk have changed dynamically, sometimes dramatically over the past two to three decades. Though the Book may serve as baby steps to a few, I am sure it can be termed as a brisk walk on risk as more than the ABC of risk, but perhaps may not be up to XYZ of risk, is covered in the book.

The most inexpensive learning is vicarious, i.e learning through the experience of others. While an intelligent person learns from others’ mistake, others learn from their own mistakes only. The function of banking encompasses a wide range of activities, all of which contribute to and change the Risk Profile of a bank in a dynamic manner. With technology and core banking in place, on-line financial mechanism gaining prominence, banks profile is never a constant phenomenon. The function of banks as repositories of funds, savings of public, payment and settlement mechanism, deployment of funds for productive purposes, etc., should never be mortgaged / surrendered to or mixed up or confused with the market trading and asset management activities, which is a function of investment banking.

Non-Performing Assets (NPAs) rose considerably as the promoters over leveraged through what is known as the nexus between the corporate and bank management. The banks have weathered the Non-Performing Asset storm to a certain extent, as the same was ruling at nearly 20% or so during 1994, when the then Income Recognition and Asset Classification (IRAC) norms, like 180 days default period, etc., were put in place in full swing. Compared to the present NPA level of nearly 3 to 4 % and Stressed Asset levels at around 10 %, even at that time it was considered in the banking circles as an understatement of factual position. This coupled with general corruption, system generated NPAs, policy delays / paralysis, swings in the interest rate scenario and abolition of Development Financial Institutions (DFIs) like ICICI, IDBI etc. paving way for banks taking long Term Loan positions in infrastructure and heavy industries, squarely nailed the banks which were supposed to handle primarily short term money in the predominant Working Capital cycle. Banks are now being blamed and are actually paying the price for this orchestrated paradigm shift in the focus, for which (exponential growth in volume owing to infrastructure and Project related Term Loans) they are not to be made responsible but can only be made accountable.

During the post Liberalisation, Privatisation and Globalisation (LPG) periods, banks tried various means to contain, control, cover up and finally eliminate the NPAs from its books through very many routes, such as, Debt Recovery Tribunals (DRT), Lok Adalat, One Time Settlements (OTS), Waiver of portion of loans, sacrifice on interest, Corporate Debt Restructuring (CDR), Asset Reconstruction Companies (ARC), etc. Almost all the aforesaid avenues promised a lot but its effectiveness was low compared to the ballooning of NPAs as the Indian Economy went for tail-spin The present level of Stressed Assets, if not NPAs, as of March 2014 were of the order of more than 10% of the Credit and the same by any standard, is quite high. It is a question of two steps forward followed by three steps backward, with resultant adverse effect. It would be better if the defaulting borrowers are made to feel that it is a matter of shame and not a badge of honour.

Considering the present financial market scenario, there is an urgent need to separate the routine banking of handling deposits and deploying funds for productive purposes and the market related trading activities which needs to adopt marked to market approach, as comparatively the later involves more risk. The real tangible asset creation activities should be disengaged from the market risk related speculative activities, which is just a gambling game. The dictum, viz., QUALITY SHOULD NEVER BE THE VICTIM OF QUANTITY is quite true in all walks of life. In fact, if a business concentrates on quality, quantitative figures would automatically chase quality and bring good volume of business. Good Corporate Governance, concentration of quality output, consciously taking risk that can be understood and hence could be managed well would pave way for driving the business in the right direction or path. Hence, notwithstanding the negative tag attached, RISK IS THE REAL BUSINESS DRIVER. But, if not managed and monitored well, it could be a Business Destroyer. Banks managing risks well raised Capital at a good premium in the market, increased their market share in Business and also rewarded the shareholders well as the market capitalization improved significantly.

According to 2013 report of international management consultancy major, in a bid to enhance Return on Equity (ROE), there may be shrinkage / merger amongst biggest banks in the world, numbering now 25 to a single digit, consequent to rationalization and consolidation in banking sector. Banking, in terms of growth in Deposits as well as Advances in general and Quality of Assets as well as profitability, is the nerve center and barometer of Indian economy.

Bankers for long have been managing the risks through traditional tools of judgment based on their past experience, without even probably perceiving or recognizing the intensity of the risks they are exposed to. Risk Management was perceived as a qualitative aspect, met through controls, procedures and guidelines without going into the statistical and analytical details of measuring in a scientific way. It was more a reactive approach than a pro-active measure and the perception of risk did not go beyond, credit failures or liquidity crises or to an extent interest rate management. With greater vulnerability to risks, an efficient management of banking entity centers around tackling the perceived risks quantitatively through a charge on capital. Risk Management is essentially a moving target approach of changing the goal post after the commencement of the game, with no defined destination, as could be witnessed in the Basel regime during the last quarter century or so from 1988, during the step by step movement from Basel I, II and III. Before we reach 2019 for compliance of Basel III norms, perhaps Basel IV might be rolled out.

Chapter-1

EVOLUTION OF BANKING

The etymology of the word Bank relates to the German word Banck, which means heap or mound or joint stock fund. The Italian word BANCO, meaning heap of money was coined, from out of this word. Another school of thought says that the bank is derived from the word Bancus or Banque which means bench. Initially the bankers, viz the Jews in Lombardy, transacted their business on benches in the market place and bench resembles to a certain extent the bank counters. If a banker failed, his banque / bench was broken up by the public. Hence the word Bankrupt has come. In other words, bankrupt means a person who has lost all his money, wealth, financial resources, etc. Money has value as long as it can be used as a medium of exchange and it loses its value when it ceases to be a medium of exchange. If you still hold it even after it has lost its value, it is akin to holding a dead body.

With technological advancement and disposable income are on the increasing trend, obviously the customer expectation is on the upswing. Banks fall over one another to extend qualitative service to ensure customer delight, which is the watch word. In pursuit of this, banks innovate service technologies, enlarge the Delivery Channels and augments customer service by going in for the marathon race in the banking field, amidst severe competition from all angles.

In India, the earliest bank started was Bank of Hindostan in the year 1770 by M/s Alexander and Company of Calcutta (Kolkata) and was closed down in the year 1832. However, subsequently three Presidency Banks were set up, viz. Bank of Bengal (Kolkata) in 1809, Bank of Bombay (Mumbai) in 1840 and Bank of Madras (Chennai) in 1843. These were quasi–government institutions incorporated under the charter from local government which also contributed

to the share capital. They were initially entrusted with the cash balances of government and management of Public Debt. In the year 1921 all these three banks were amalgamated into Imperial Bank of India with the Deposit and Advances figures of Rs 73 cr. and Rs 54 cr. respectively, spread over nearly 80 branches. Imperial Bank of India was later converted into State Bank of India, in 1955.

Subsequently, Banks nationalization was done in the year 1969, by the then Prime Minister Smt. Indira Gandhi and has already completed more than four and a half decades. This Book covers the performance and risk management aspects of primarily the Public Sector Banks, during the intervening period and also nearly six and a half decades since independence, knowing fully well that the banking sector is poised for a sea change imminently, as the third tranche of new Banking Licenses gets fructified in 2015. However, the commercial banks in India have more than a two century history. As per the report of Boston Consultancy Group, by 2025 India is poised for occupying 3rd in the ranking according to the asset size, fuelled by mobile banking enabled through 3G or 4G as well as smartphone technologies. Considering the IT talent pool that India can boost of, the best banks in India can be amongst the most technology efficient banks coupled with human touch.

According to section 5 (b) of the Banking Regulation Act, 1949, Banking is accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawal by cash, cheque, draft or otherwise. Banking is nothing but efficiently mobilizing low cost deposits from savers, who otherwise have low return options and then efficiently allocating funds to credit worthy borrowers who have too few Capital Funds to be deployed on any viable project / business proposal / opportunities.

Section 49 (a) prohibits any institution, other than banking company, to accept deposit money from public for withdrawal by cheque. Banking is basically taking risks and more importantly, taking those risks using judicious discretion all through. The overall banking business in the year of independence in 1947, nationalization in 1969 and the present one, as revealed in the following table, throw a bird’s view of the growth in the banking sector during the sixty seven years period.

(Rs in cr.)

With increase in the number of bank branches significantly from about less than 100 branches in 1947 to more than 88,000 (43% in rural areas covering 5 lakhs villages) in 2014, the total business of the bank has also leapfrogged, with Compounded Annual Growth Rate (CAGR) of nearly 15 % for more than six and a half decades, a creditable achievement by any standard. Population per branch is coming down, owing to virtual banking gaining momentum. During the last couple of years, while many global Financial Institutions failed, in India on account of the stringent regulatory measures, we have been able to neutralize the effect of global meltdown in the financial sector. It is perceived that savers have some difficulties in accessing banking activities, which is why the concepts of Financial Inclusion and Financial Literacy have gained prominence and banks do not have the tools to provide positive real interest rate on the money kept with them. This paved way for the general populace to move away from financial asset into physical asset. Banking is all about how to ensure exponential growth in the financial assets, while simultaneously playing a vital role in creation of physical asset, through the financial asset.

Banking is the nerve center of economic growth, as could be evidenced in the above growth figures. Unlike US, in India economic growth is often enjoyed by a few while financial burden on account of growth falls on the shoulders of large populace. As could be seen since independence, growth is sure to happen, while the gulf between haves and have-nots kept on widening.

RESERVE BANK OF INDIA

As per the Banking Enquiry Committee, on the basis of the recommendations of Hilton and Young, the Reserve Bank of India Act was passed in 1934 and the Reserve Bank of India (RBI) was established in the year 1935 with fully paid up share capital of Rs 5.00 cr., in the private sector to regulate issue of Bank Notes, securities, monetary stability in India and to operate the currency and credit system of the country to its economic development. Later, after independence in 1947, the entire share capital was acquired by the Government of India and the RBI was nationalized in 1949. It may be interesting to note that the paid up capital of RBI continues to remain at the same level of Rs 5 cr., even now, notwithstanding the fact that it has been advocating for capital infusion in general and capital adequacy in particular, in the case of commercial banks. During the early stages, when funds were scarce, the Credit Control methods employed by the RBI encompassed both qualitative and quantitative measures which are briefed herein below:

Quantitative measures

a. Variation of Reserve Ratios i.e Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

b. Open Market Operations

c. Repos or Repurchase transactions

d. Bank Rate policy

Qualitative measures

a. Fixation of Margin requirements

b. Rationing of credit, particularly when there is credit squeeze

c. Regulation of consumer credit

d. Controls through directives

e. Moral suasion

f. Publicity

g. Direct Action.

Now, in 2014, with a view to have broad functional homogeneity, RBI is attempting to restructure its organizational functions into a group of 5 Clusters, under the following name and style:

1. Banking Services and Regulations

2. Supervision and Risk Management

3. Financial Markets and Infrastructure

4. Operations and Human Resources

5. Monetary Stability

With the above classifications of its focused approach, the functional Departments of RBI are slated to spread across and increase from below 30 to around 35. By setting Inflation Target, the central government is overhauling the framework of Monetary Policy, as the center facilitates RBI to move to a Modern Monetary Policy regime. It is very vital for the central Government in power and the RBI to periodically engage in dialogues on sustainable Monetary Policy framework that can balance inflation control without a compromise or sacrifice on economic growth objectives in at least Arithmetical Progression, if not on Geometric Progression basis. The couplet of center specifying inflation target and RBI enjoying freedom of interest stipulation should be the ideal environment for the smooth functioning of banking sector. Inflation Targeting concept advocated by the Government would effectively diminish the role of RBI, the Regulator. In the context of Indian economy requiring to large populace with low income, it is desired by political authority to have a say in the matter of inflation and interest for, these significantly impact the living style of populace largely.

RBI’s autonomy is not sanctioned by statue and it can only be as autonomy as the Government in power wants it to be. Nevertheless, presently, the final call on interest rate is taken normally by the Governor of RBI, though he consults his Deputy Governors, reckons the advice of Technical Advisory Committee with external members on Monetary Policy and holds discussions with Chiefs of Banks.

Like the Reserve Bank of India, details of the central bank or the regulator as the case may be in some of the major countries are detailed below:

Top four Chinese banks and PSUs in China are going ahead and occupying top ranks in the world ranking. However, Banks in India, despite longer period of history as well as relatively better regulated by the central bank have not lived up to the expectation. RBI, which according to the RBI Governor, neither hawks nor doves, is actually owls as it is vigilant when others are at rest. With more than eight decades having been lapsed since its formation, the RBI Act 1935 need a new look with grant of greater autonomy in its functions. As both the Governor and several Deputy Governors are being appointed by the central Government, the top management of the RBI functions under the clutches of the Government in power, at any point of time, notwithstanding the fact that administratively, RBI’s reputation in international market in times of Economic Crises, remained in-tact. The Reserve Bank of India should be allowed to act as a sole and universal Regulator so as to maintain unity of command.

R B I Panels headed by A S Ganguly and P J Naik in 2014 consistently recommended functional bifurcation / separation of the single post of Chairman and Managing Director into Chairman and Chief Executive Officer / Managing Director(s), with some minimum tenure of three to five years or so in the case of Public Sector Banks. This separation is aimed at ensuring better governance and more transparency so as to bring about more focus on strategy and vision besides thrust on operational aspects.

The Reserve Bank of India rates Domestic Banks under the broad parameters of Capital Adequacy, Asset Quality, Management Efficiency, Earnings Capacity, Liquidity and Systems & Controls – known as CAMELS, acronym of the above parameters. On behalf of RBI, the currency notes are being printed by Security Printing and Minting Corporation of India Ltd.

STATE BANK OF INDIA

In 1955, the SBI Act was passed by nationalizing the Imperial Bank of India and SBI emerged with the objectives of providing banking facilities on a large scale in rural and semi urban areas for various public purposes. Nationalization of Imperial Bank of India heralded the entry of public sector culture into the commercial banking. In 1959, SBI (subsidiary banks) Act was passed and the following eight banks were formed, viz. State Bank of Bikaner, State Bank of Jaipur, State Bank of Indore, State Bank of Mysore, State Bank of Patiala, State Bank of Hyderabad, State Bank of Saurashtra and State Bank of Travancore. The first two banks were merged in 1963 as the now existing State Bank of Bikaner and Jaipur. Now, the merger of State Bank of Saurashtra and State Bank of Indore with the parent SBI has taken place. As of 2014, SBI has FIVE subsidiaries viz. SBBJ, SBH, SBM, SBP and SBT, in its fold. The State Bank of India is placed at the 70th Rank in the Global scenario and is the number one bank in India, followed by the ICICI Bank Ltd and HDFC Banks Ltd., which are in the private sector domain. As of 2014, SBI has in its role more than two lakh personnel with domestic branch network of more than 15,000 branches spread through the nook and corner of India and international presence in more than 35 countries. It is a class of its own with deep rooted brand equity, particularly among the rural populace.

BANK NATIONALISATION

Apart from the State Bank of India, twenty commercial banks were nationalized in two tranches on 19th July 1969 (14 banks having Deposit of Rs 50 cr and above) and again on 15th April 1980 (6 banks having Deposit of Rs 200 cr and above). Justifying the nationalization, the former Prime Minister, Late Smt. Indira Gandhi, in the Radio broadcast to the nation, as there was no Television in India at that time, had stated as follows:

An institution such as the banking system, which touches and should touch the lives of millions has necessarily to be inspired by a larger social purpose and has to sub-serve national priorities and objectives. That is why there has been a wide spread demand that major banks should be not only socially controlled, but also, publicly owned. This step, now taken, is a continuation of the process which has been underway. It is my earnest hope that it will mark a new and more vigorous phase in the implementation of an avowed plans and policies.

Notwithstanding the growth of new Private Sector Banks since mid-nineties, the above statement holds water as the present Government goes about on Jan Dhan Scheme.

It is reported that every passing day bears out the wisdom of the then Prime Minister who took a very bold decision to nationalize some of the banks, more than four and a half decades ago. At the time of nationalization of banks in the year 1969, the data pertaining to commercial banks were as follows. (Rs in cr.)

The following is the Deposits and Advances figures along with the number of branches at the time of nationalization of 20 banks in 1969 and 1980.

(Rs in cr.)

*merged with Punjab National Bank in 1996. At present these are the PSBs in addition to IDBI Bank and SBI with its associates

In a closed market environment where number of foreign bank branches was restrained from expansion and foreign equity in banks were restricted, PSU banks’ businesses were protected, but they were left with catering to the masses. The PSU banks accounts for more than 75 % market share. As against the present market share of top 5 & 10 banks respectively at around 75 % and 85 % in China, in India, the market share of the top 5 banks is 42% and that of 10 banks is 57 %, revealing the fact that top ten banks in India are not that much big in volume of business and the situation is not likely to significantly improve to compete with international banks in a big way.

Generally, in a study on banking, banks are categorized into four or five groups such as Public Sector Banks (consisting of SBI group with its five subsidiaries & 19 nationalised banks), old private sector banks, new generation private sector banks and foreign banks, in all. The table of Assets & aggregate Net Profit generated in the banking sector, in percentage terms across the categories of banks, is as follows:

Holding merely 6 % of assets and generating nearly 13 % net profit as above is mainly on account of disproportionate operating expenses and income level for a given volume of business, caused by technology variation and geographical presence. Encouraging other sector banks, by subjecting the PSU banks to repeated comparison on profitability, productivity, efficiency etc. would indirectly force the PSBs to change their lending and banking practices, which would not be in the best interest of the nation, for the reason that objectives of the two are as different as chalk and cheese

With more than two third of Deposits, Advances, Branch network, customer base, etc., Public Sector Banks play a very vital role in the overall economics markets in general and financial sectors in particular. Apart from profitability, Asset Quality is the area where the PSBs lag behind the others for the obvious reasons of social commitments, developmental activities and obligations. Rising Non-Performing Assets may have stolen some of the shines of Public Sector Banks, but practically speaking, these may not be the sole creation of the respective banks alone.

Many public sector enterprises could not compete well and remain profitable in the customer centric enterprises, viz. B2C (Business to Customer) segment as entry of private players virtually driven out some of the enterprises. EC TV lost business to Onida, Samsung, Sony, etc.; hmt to Titan; Indian Airlines / Air India to Jet Airways, low cast carriers; However when it comes to bank only the share has come down and it is around 75 % now, as the entry of new players like ICICI Bank, HDFC Bank, Axis Bank, Kotak Bank, Yes Bank, IndusInd Bank gained grounds in banking. Thus unlike the manufacturing PSUs, finance PSUs are relatively better off. The only plus point in some of the manufacturing PSU units is the likely monetization of Immovable properties.

With ideal mix of category of banks, greater breadth of product, depth in delivery channel, efficiency in operations, without losing focus on customer needs of Indian populace, have been achieved. In banking, profit is dependent on a number of factors of which some like Operating Expenses, Net Interest Margin, Asset Quality, Sourcing of Funds at a low cost & Other Income are within the control of banks and some like interest rates, RBI directives, financial accounting standards, technological advances, etc. are outside the control of banks. Since nationalization of banks in 1969, nearly 35 mergers have taken place, 26 led by public sector and nine among private sector