The Indian Banking Industry

TABLE
Topic Page

EVOLUTION OF BANKING 4
PRE-INDEPENDENCE (1786-1947) 4
POST-INDEPENDENCE 5
STRUCTURE OF THE BANKING SECTOR 8
PUBLIC SECTOR BANKS 9
PRIVATE SECTOR BANKS 10
FOREIGN BANKS 12
CONCENTRATION IN THE BANKING SECTOR 13
SECTORAL TRENDS IN CREDIT DEPLOYMENT 15
BANKING SECTOR REFORMS 21
ASSETS AND LIABILITIES STRUCTURE OF SCBS 22
LIABILITIES 27
ASSETS 28
STRUCTURAL REFORMS 32
IMPACT OF REFORMS ON BANKS 35
PROFITS 35
CAPITAL ADEQUACY 36
DEPOSIT GROWTH 37
ASSET QUALITY AND NON-PERFORMING LOANS 37
BANKING INDUSTRY PERFORMANCE 39
INCOME 40
YIELDS 44
INTEREST COST 48
SPREADS 50
INTERMEDIATION COSTS 52
PROFITABILITY 56
RETURN ON ASSETS 57
CAPITAL ADEQUACY 60
ASSET QUALITY 63
COMPETITION FROM OTHER INSTITUTIONAL INTERMEDIARIES 70
FINANCIAL INSTITUTIONS 70
NON-BANKING FINANCE COMPANIES 77
MUTUAL FUNDS 80
FINANCIAL DISINTERMEDIATION 82
DOMESTIC TRENDS 86
MERGERS 86
CONSUMER BANKING 88
INTERNET BANKING 88
ANNEXURE: KEY INDICATORS OF INDIAN SCBS 89
CONTENTS
 Introduction

In India, given the relatively underdeveloped capital market and with little internal
resources, firms and economic entities depend, largely, on financial intermediaries to
meet their fund requirements. In terms of supply of credit, financial intermediaries can
broadly be categorised as institutional and non -institutional. The major institutional
suppliers of credit in India are banks and non -bank financial institutions (that is,
development financial institutions or DFIs), other financial institutions (FIs), and non-
banking finance companies (NBFCs). The non-institutional or unorganised sources of
credit include indigenous bankers and money-lenders. Information about the unorganised
sector is limited and not readily available. An important feature of the credit market is its
term structure: (a) short-term credit; (b) medium-term credit; and (c) long-term credit.
While banks and NBFCs predominantly cater for short-term needs1, FIs provide mostly
medium and long-term funds.
 EVOLUTION OF BANKING

Pre-Independence (1786-1947)

The evolution of the modern commercial banking industry in India can be traced to
1786 with the establishment of Bank of Bengal in Calcutta (now Kolkata).
Subsequently, three Presidency Banks were set up—at Calcutta in 1806, Bombay
(now Mumbai) in 1840, and Madras (now Chennai) in 1843. In 1860, the concept
of limited liability was introduced in banking, resulting in the establishment of a
number of joint sector banks. The early 1900s led to the establishment of a number
of indigenous joint stock banks, such as the Bank of India, Bank of Baroda, and the
Central Bank of India.

In 1921, the three Presidency Banks were amalgamated to form the Imperial Bank
of India (IBI). This new bank took on the triple role of a commercial bank, a
banker's bank and a banker to the government. The establishment of the Reserve
Bank of India (RBI) as the central bank of the country in 1935 ended the quasi-
central banking role of the IBI. It ceased to be banker to the Government of India
(GoI) and instead became agent of the RBI for the transaction of government
business at centres at which RBI was not established. IBI also acted as a bankers'
bank by holding their surplus.
 Post-Independence

India inherited a weak financial system after Independence in 1947. At end-1947,

there were 625 commercial banks in India, with an asset base of Rs. 11.51 billion.
Commercial banks mobilised household savings through demand and term
deposits, and disbursed credit primarily to large corporations. Following
Independence, the development of rural India was given the highest priority. The
commercial banks of the country including the IBI had till then confined their
operations to the urban sector and were not equipped to respond to the emergent
needs of economic regeneration of the rural areas. In order to serve the economy in
general and the rural sector in particular, the All India Rural Credit Survey
Committee recommended the creation of a state-partnered and state-sponsored
bank by taking over the IBI, and integrating with it, the former state-owned or
state-associate banks. Accordingly, an act was passed in Parliament in May 1955,
and the State Bank of India (SBI) was constituted on July1, 1955. More than a
quarter of the resources of the Indian banking system thus passed under the direct
control of the State. Subsequently in 1959, the State Bank of India (Subsidiary
Bank) Act was passed (SBI Act), enabling the SBI to take over 8 former State-
associate banks as its subsidiaries (later named Associates).

The GoI also felt the need to bring about wider diffusion of banking facilities and
to change the uneven distribution of bank lending. The proportion of credit going
to industry and trade increased from a high 83% in 1951 to 90% in 1968. This
increase was at the expense of some crucial segment of the economy like
agriculture and the small-scale industrial sector. Bank failures and mergers resulted
in a decline in number of banks from 648 (including 97 scheduled commercial
banks or SCBs and 551 non -SCBs) in 1947 to 89 in 1969 (compr ising 73 SCBs
and 16 non -SCBs). The lop-sided pattern of credit disbursal, and perhaps the spate
of bank failures during the sixties, forced the government to resort to
nationalisation of banks. In July 1969, the GoI nationalised 14 scheduled
commercial banks (SCBs), each having minimum aggregate deposits of Rs. 500
million. State-control was considered as a necessary catalyst for economic growth
and ensuring an even distribution of banking facilities. Subsequently, in 1980, the
GoI nationalised another 6 banks2, each having deposits of Rs. 2,000 million and
above.
The nationalisation of banks was the culmination of pressures to use the banks as
public instruments of development. The GoI imposed `social control’ on banks, of
which priority sector lending was a major aspect. It introduced restrictions on
advances by banking companies. These were intended to ensure that bank advances
were confined not only to large-scale industries and big business houses, but were
also directed, in due proportion, to other important sectors like agriculture, small-
scale industries and exports.

Since 1969, there has been a significant spread of the banking habit in the economy
and banks have been able to mobilise a large amount of savings. While the number
of bank offices has increased from 8,262 in June 1969 to 68,561 in March 2003,
average population per office has declined from 64,000 to 16,000. While aggregate
deposits of commercial banks have increased from Rs. 46.46 billion in June 1969
to Rs. 12,809 billion in March 2003 (Rs. 15,019 billion at end-March 2004), credit
has also increased from Rs. 35.99 billion to Rs. 7,292 billion (Rs. 8,354 billion at
end-March 2004). The 1969 nationalisation had raised public sector banks’ (PSBs)
share of deposit from 31% to 86%, while the nationalisation of 1980 raised the
same to 92%.

However, by the 1980s, it was generally perceived that the operational efficiency
of banks was declining. Banks were characterised by low profitability, high and
growing nonperforming assets (NPAs), and low capital base. Average returns on
assets were only around 0.15% in the second half of the 1980s, and capital
aggregated an estimated 1.5% of assets. Poor internal controls and the lack of
proper disclosure norms led to many problems being kept under cover. The quality
of customer service did not keep pace with the increasing expectations.
In 1991, a fresh era in Indian banking began, with the introduction of banking
sector reforms as part of the overall economic liberalisation in India.
 STRUCTURE OF THE BANKING SECTOR

The banking sector in India functions under the umbrella of the RBI—the
regulatory, central bank. The Reserve Bank of India Act was passed in 1934 and
the RBI was constituted in 1935 as the apex bank. The Banking Regulations Act
was passed in 1949. This Act brought the RBI under government control. Under
the Act, the RBI received wide-ranging powers in
regards to establishment of new banks, mergers and amalgamations of banks,
opening and closing of branches of banks, maintaining certain standards of banking
business, inspection of banks, etc. The Act also vested licensing powers and the
authority to conduct inspections with the RBI.

Banks in India can broadly be classified as regional rural banks or RRBs,

scheduled commercial banks or SCBs, and co-operative banks. The scope of the
present comment includes the SCBs only.

The SCBs for the purpose of this comment can be classified into the following
three categories:

• Public sector banks or PSBs (SBI & its associates, and nationalised banks);

• Private sector banks (old and new); and

• Foreign banks.

ABLE OF CONTENTS

CREDIT MARKET STRUCTURE

In India, given the relatively underdeveloped capital market and with little internal
resources, firms and economic entities depend, largely, on financial intermediaries
to meet their fund requirements. In terms of supply of credit, financial
 intermediaries can broadly be categorised as institutional and non -institutional.
The major institutional suppliers of credit in India are banks and non -bank
financial institutions (that is, development financial institutions or DFIs), other
financial institutions (FIs), and non-banking finance companies (NBFCs). The non-
institutional or unorganised sources of credit include indigenous bankers and
money-lenders. Information about the unorganised sector is limited and not readily
available. An important feature of the credit market is its term structure: (a) short-
term credit; (b) medium-term credit; and (c) long-term credit. While banks and
NBFCs predominantly cater for short-term needs1, FIs provide mostly medium and
long-term funds.

Structure of Indian Banking Industry at end-March 2003 (end-

FY2003)

At end-FY2003, these SCBs had a network of 53,882 offices, and total assets
worth Rs. 16,989 billion, making them the most active and dominant financial
intermediaries in the country.

Public Sector Banks

The banking sector in India has been characterised by the predominance of PSBs.
The PSBs had 47,677 offices (SBI & associates: 13,735; nationalised banks:
33,942) at end-FY2003, and their assets of Rs. 12,852 billion at end-FY2003
accounted for 75.7% of assets of all SCBs in India. An estimated 63.4% of the
offices of PSBs at end-FY2003 were in these areas: rural/semi-urban.

The PSBs’ large network of branches enables them to fund themselves out of low-
 cost deposits. At end-FY2003, PSBs accounted for 75.7% of assets, 79.6% of
deposits, 74.2% of advances, 74.5% of income, and 88.7% of offices of all SCBs in
India, thus clearly demonstrating their dominance of the Indian banking sector.
However, PSBs have suffered a gradual loss of market share, mainly to new private
sector banks. PSBs accounted for 80% of asset growth of SCBs during FY2003,
compared with 51.9% during FY2002, and 75.3% during FY20014.

Select Indicators—PSBs
End-FY2003

(Courtesy: Reuters

SBI is the largest PSB, and also the largest SCB in India. At end-FY2003, SBI
accounted for 22.1% of the aggregate assets of all SCBs in India. Further, five out
of the six largest SCBs in India are PSBs (refer Table below). The below
mentioned six SCBs accounted for 47.3% of assets of all SCBs in India at end-
FY2003.

Major SCBs in India at end-FY2003

A
ICICI Bank is a new private sector bank
Courtesy: Reuters

Private Sector Banks

As of end-FY2003, there were 30 private sector banks operating in India through

5,879 offices. These can further be classified as old (OPBs) and new private sector
 banks (NPBs). At end-FY2003, there were 21 OPSBs operating in the country.
These banks had an estimated 4,737 offices at end-FY2003, are regional in
character and, except for a few, have a comparatively small balance sheet size.
In July 1993, as part of the banking sector reform process and as a measure to
induce competition in the banking sector, the RBI permitted entry by the private
sector into the banking system. This resulted in the introduction of 9 private sector
banks. These banks are collectively known as the `new’ private sector banks
(NPBs), and operated through an estimated 988 branches at end-FY2002. With the
merger of Times Bank Limited into HDFC Bank Limited in February 2000, and
the entry of Kotak Mahindra Bank Limited (KMBL) during March 2003, there are
nine NPBs in India at present.

Select Indicators—Private Sector Banks

Courtesy: Reuters

At end-FY2003, the total assets of private sector banks aggregated Rs. 2,973
billion and accounted for 17.5% of the total assets of all SCBs. Although the share
of private sector banks in total assets has increased from 12.6% at end-FY2001,
most of the gain has been accounted for by NPBs. The share of NPBs in the share
of assets of all private sector banks increased from 27.5% at end-FY1997 (2.4% of
assets of SCBs) to 64.6% at end-FY2003 (11.3% of assets of SCBs). By contrast,
the share of OPBs banks (in total assets of SCBs) has declined from 6.4% at end-
FY1997 to 6.2% at end-FY2003; their share of assets of private sector banks has
declined from 72.5% at end-FY1997 to 35.4% at end-FY2003. At end- FY2003,
three (ICICI Bank, HDFC Bank, and UTI Bank) of the five largest private sector
banks (by asset size) were NPBs (refer Table below). The five largest private
sector banks controlled 62.5% of assets of all private sector banks at end-FY2003.
Major Private Sector Banks in India at end-FY2003
(Rs. billion)

Courtesy: Reuters

Foreign Banks

At end-FY2003, 36 foreign banks were operating in India through 208 offices. All
offices of foreign banks were in urban and metropolitan areas. At end-FY2003, the
total assets of foreign banks aggregated Rs. 1,164 billion and accounted for 6.9%
of the total assets of all SCBs (refer Table below). In recent years, because of
closures and increased competition from NPBs, the share of foreign banks in
aggregate assets of SCBs has declined from 8.1% at end- FY1999.

Select Indicators—Foreign Banks

End-FY2003
(

Courtesy: Reuters CBs

The biggest foreign bank in India by asset size is Standard Chartered Bank,
followed by Citibank, and the Hongkong & Shanghai Banking Corporation
(HSBC) (refer Table below). As of end-FY2003, the five largest foreign banks
accounted for 77.9% of assets of all foreign banks in India.

Major Foreign Banks in India at end-FY2003

(Rs. billion)
Assets Deposits Advances Investments Income
Source: rbi.org/

The primary activity of most foreign banks in India has been in the corporate
segment. However, in recent years, foreign banks have started making consumer
financing a larger part of their portfolios, based on the growth opportunities in this
area in India. These banks also offer products such as automobile finance, home
loans, credit cards and household consumer finance.

CONCENTRAT ION IN THE BANKING SECTOR

The concentration in the Indian banking sector has declined gradually during the
last few years. This is illustrated by table below. While the share of the largest SCB
—SBI—has declined only gradually, other PSBs have lost gradual market share to
NPBs. Overall, while the share of the five largest banks in total assets has declined
from 45.2% at end-FY1997 to 42.8% at end-FY2003, the share of the ten largest
banks has declined from 60.3% to 58.2%. As the table below illustrates, PSBs have
gradually lost market share to NPBs. However, amongst the PSBs, the share of the
SBI & associate banks has increased at the expense of the nationalised banks—
from 36.7% of assets of PSBs at end-FY1997 to 38.4% at end- FY2003.
Nationalised banks have witnessed the most significant decline in share of assets of
all SCBs—from 52.5% at end-FY1997 to 46.6% at end-FY2003. They have lost
market share mainly to NPBs, whose share of total assets increased from 2.4% at
end-FY1997 to 11.3% at end-FY2003. Foreign banks, with limited branch
presence, have also witnessed a decline in share of assets. NPBs have expanded the
most in the deposit market as well, with their share of total deposits increasing
from 2.4% at end-FY1997 to 8.5% at end-FY2003. By comparison, the share of
nationalised banks declined from 56.2% to 50.8%.
 Share of total assets of SCBs in India
(Percent of assets of all SCBs)
As 2

Source: goidirectory.nic.in

An analysis of the state-wise share of deposits and credit indicates that at end-
FY2003, PSBs continue to be dominant (with more than 85% of deposits of SCBs)
in many major states—Uttar Pradesh, Punjab, Madhya Pradesh, Rajasthan, Bihar,
Haryana, and Orissa.

Share of bank deposits in major states

Foreign banks, despite the apparently superior quality of services they offer, have
not been a major competitive threat in Delhi, West Bengal, Maharashtra,
 Karnataka, and Tamil Nadu, where their presence is greatest. These five states
accounted for an estimated 94.4% of deposits of foreign banks at end-FY2003. In
fact, foreign banks have lost market share in these states—from 12.5% of deposits
at end-FY1999 to 8.5% of deposits at end-FY2003. Private sector banks have
gained more than 25% of deposits in many major states— Maharashtra, Tamil
Nadu, Kerala, and Jammu & Kashmir—but the impact on PSBs is smaller than on
foreign banks. The trends so far indicate that, even after a decade of reforms, PSBs
continue to dominate in most of the states.
SECTORAL TRENDS IN CREDIT DEPLOYMENT
An analysis of gross bank credit (GBC)6 of SCBs reveals that while the share of
industry has declined from 50.1% at end-FY1998 to 42.4% at end-FY2002, the
share of personal loans has increased from 10.4% to 12.3%. Similarly, the share of
agriculture in total credit has also declined from 9.5% at end-FY1998 to 8.7% at
end-FY2002.
Distribution of outstanding credit of SCBs—end FY1998 to end-FY2002
(in percent)

As at end March
An analysis of GBC of select SCBs accounting for 85—90% of bank credit of all
 SCBs indicates that GBC to agriculture increased 17.9% during FY2003, as
compared with growth of 17% during FY2002, and 17% during FY2001. The
agricultural sector was impacted by a severe drought in 2002, with the monsoon
season rainfall (June-September 2002) being 81% of normal. This adversely
impacted on the farm sector in several States, producing a contraction in real GDP
originating from `agriculture and allied activities’. The production of food grains
was adversely affected with a 14.6% decline to 182.6 million tonnes during
FY2003. As a result, GDP from agriculture declined 3.2% during FY2003.
During FY2003, industrial sector recovered as evident in a sharp rise in the
production and imports of capital goods. Industrial performance is dominated by
the behaviour of manufacturing, and during FY2003, the manufacturing sector
contributed 86% of the growth of overall industrial production. The industrial
recovery enabled a healthy growth in exports, and resulted in upswing in non -food
credit from the banking system. The industrial sector GDP increased 5.7% during
FY2003 because of improvements in infrastructure, lag effect of increased
agricultural output during FY2002, and improvement in exports. Industrial activity
was broadly insulated from the impact of the drought, except in the durable
consumer goods segment.

Sectoral Real Growth rates in GDP at factor cost—1993-94 prices

Nin
th Plan
(FY1998-
Reflecting the recovery in industrial activity from March 2002, GBC to industry
(medium and large) increased 16.3% during FY2003, as compared with increases
of 5.8% during FY2002, and 10.5% during FY2001. The recovery permeated all
segments during FY2003, with manufacturing contributing more than 80% of the
overall growth of industrial production. Indian industry was largely insulated from
the impact of the drought, except in the durable consumer goods segment where
production was adversely impacted. In recent years, there has been increased share
of GBC to housing and other non-priority sector personal loans. GBC to housing
increased 55.1% during FY2003, as compared with growth of 38.4% during
FY2002, and 14.5% during FY2001. Accordingly, the share of housing loans in
GBC increased from 3.4% at end-FY2001 to 5.6% at end-FY2003. Housing loans
accounted for 15.4% of incremental GBC during FY2003, as compared with 9.2%
during FY2002, and only 3% during FY2001. During FY2003, growth of credit to
housing continued to remain high, because of tax incentives as well as the decline
in interest rates. In May 2002, RBI liberalised the prudential requirements for
housing finance by banks and investment by banks in securitised debt instruments
of housing finance companies (HFCs). Residential housing properties now attract a
risk weight of 50% as compared with the previous 100%. Because of liberalised
prudential requirements and general decline in interest rates, there has been a
significant decline in the interest rates charged by banks on housing loans. Many
banks have set their lending rates lower on housing loans, and at times below PLR,
due to lower risk weight. Many banks have con sistently exceeded the targets
prescribed for providing housing loans during FY2002 and FY2003. While
minimum prescribed allocations for housing finance by SCBs increased from Rs.
50.46 billion during FY2002 to Rs. 85.74 billion during FY2003, disbursements
increased from Rs. 147.46 billion to Rs. 338.41 billion.
 Sectoral Deployment of Gross Bank Credit

-03 21-03-03
22-03-02
As compared with PSBs, foreign banks have placed increased thrust on consumer
financing, which has enabled them to enjoy consistently higher yields and margins.
Personal loans accounted for 23.6% of outstanding credit of foreign banks at end-
FY2002, as compared with 18.9% at end-FY2001. By contrast, with the slowdown
in the economy, PSBs have only recently placed increased focus on consumer
financing. Personal loans accounted for 12.5% of their credit at end-FY2002, as
compared with 11.7% at end-FY2001, and 9.9% at end- FY1998.

Bank Group-wise distribution of outstanding credit—end-FY2000 to end-FY2002

As the following table indicates, industry wise, the largest credit growth over the
past five years has been observed in power, roads and ports, computer software,
telecom, gems & jewellery, petrochemicals, cement, electricity, and food
processing. By contrast, GBC has declined or stagnated in traditional commodity
sectors such as jute textiles, tobacco & tobacco products, leather & leather
products, rubber & rubber products, tea, and vegetable oils. During FY2003, while
GBC to industry—small, medium and large—increased 13.6% to Rs. 2,608.21
billion, some major industries showed a decline in GBC. The important amongst
these were coal, sugar, tobacco & tobacco products, and other engineering. By
comparison, some important industries that have showed an increase in GBC
during FY2003 include computer software (growth of 52%), roads & ports
(49.3%), power (45.8%), cement (22.6%), electricity (20.9%), cotton textiles
(18%), and gems & jewellery (16.8%).
 Industry wise deployment of gross bank credit

(Percent)

As on last

As on last reporting Friday of March 2003 2002 2001 2000 1999

 BANKING SECTOR REFORMS

In general, the post-nationalisation period during the 1970s and 1980s was marked
by a high degree of regulation and control. The two dominant financial
intermediaries—commercial banks and long-term lending institutions—had
mutually exclusive roles and objectives and operated in a largely stable
environment, with little or no competition. Long-term lending institutions were
focused on the achievement of the GoI’s various socio-economic objectives,
including balanced industrial growth and employment creation, especially in areas
requiring development. They were extended access to long-term funds at
subsidized rates through loans and equity from the GoI and from funds guaranteed
by the GoI, originating from commercial banks in India and foreign currency
resources, originating from multilateral and bilateral agencies. The banks
functioned in a heavily regulated and controlled environment, with an administered
interest rate structure, quantitative restrictions on credit flows, high reserve
requirements, and pre-emption of a significant proportion of lend able resources
towards the `priority’ and government sectors. The banks formed a captive pool of
resources for the government's borrowings. Since the government was the largest
borrower in the economy, it could assume the role of price maker. The imposition
of high statutory liquidity reserve (SLR) requirements and cash reserve ratio (CRR)
requirements and priority sector norms led to a significant reduction in the bank
operational flexibility in asset deployment, and to credit rationing for the private
sector. Interest rate controls led to sub-optimal use of credit, and low levels of
investment and growth. The administered interest rate system worked on cost-plus
pricing. The RBI worked out the lending and deposit rate structure to ensure that
banks got a decent spread for their operations. The resultant heavy regulation led to
a decline in productivity and efficiency. Although the business volumes improved,
asset quality suffered because of the higher incidence of concessional and directed
lending. To evaluate the systemic banking problems, the GoI set up a nine-member
Committee on Financial Systems, under the chairmanship of Mr. N. Narasimham,
in 1991. The Narasimham Committee Report, published towards the end of 1991,
 contained far-reaching recommendations for the banking sector and formed the
basis of the sector’s reform process.

These reforms were undertaken together with, and formed an important element of,
the overall economic reforms of the 1990s. The salient features of these reforms
were:
• introduction of stricter income recognition and asset classification norms;
• introduction of higher capital adequacy requirements;
• introduction of higher disclosure standards in financial reporting;
• introduction of phased deregulation of interest rates;
• and lowering of SLR and CRR requirements.

Assets and Liabilities Structure of SCBs

The reforms in the banking sector were targeted at both the asset and the liability
sides of the balance sheet. Before the banking sector reforms are discussed in
detail, it would perhaps be instructive to look at how Indian banks raise funds and
how these funds are deployed. The liability profile of the Indian banking sector is
presented in the following Table.

Liability Profile
As the Table shows, the major sources of funds for the Indian banking sector are
deposits, which accounted for 79.8% of SCBs’ liabilities at end-FY2003, as
compared with 81.1% at end-FY1999. Deposits are of three kinds:
Demand deposits, accounting for 12.1% of deposits of SCBs at end-FY2003,
carry zero interest and are, typically, used by corporates for storing funds for short
periods. Demand deposits offer unlimited liquidity in that they can be withdrawn at
any time.
Savings deposits offer only a slightly lower degree of liquidity but carry a low
interest rate (presently 3.5% per annum). Savings deposits accounted for 22.3% of
the deposits of SCBs at end-FY2003. However, the operating costs of servicing
these deposits are high as they consist of a large number of small value accounts
that are geographically widespread (61% of savings deposit accounts of SCBs are
in rural and semi-urban areas). SCBs try to enhance the share of savings deposits
from retail customers as these offer lower costs as well as higher stability.
Term deposits are the most illiquid of the three and carry the highest interest cost.
Term deposits can have a minimum maturity of 15 days7. Term deposits accounted
for 65.6% of deposits of SCBs at end-FY2003. In terms of maturity, only 34.8% of
term deposits at end-FY2002 had a maturity of less than 1 year. Nearly 55.4% of
term deposits were for maturity periods of 1 to 5 years. An estimated 9.8% of term
deposits were for maturity periods exceeding 5 years.

An analysis of bank deposits by type indicates that the `household sector’

accounted for 66.7% of outstanding deposits of SCBs at end-FY2002, followed by
Government (10.6%), foreign (10.2%), financial sector (6.9%), and private
corporate—non financial (5.7%). At end-FY2002, households accounted for 87.3%
of savings deposits of SCBs, 62.8% of term deposits, and 46.3% of current
deposits. Despite the significant increase in branch network, urban and
metropolitan branches of SCBs accounted for 66.4% of deposits of all SCBs at
end-FY2002.
There is a flow of resources from the rural/semi-urban branches as indicated by the
fact that the credit extended by rural/semi urban branches of SCBs is less than the
deposits of these branches.
 Apart from deposits, the other major source of funds is a bank’s net worth. Banks
are required to fund a certain proportion of their assets (weighted by their risk) by
their net worth. This proportion is known as the capital adequacy ratio (CAR). For
all SCBs, the minimum CAR was increased from 8% to 9% from the year ended
March 31, 2000, as per Basel norms, covering both on and off-balance sheet items.

Liability Profile of SCBs

The asset profile of SCBs in India is presented below:

Asset Profile of SCBs—end-FY2003

Source: goidirectory.nic.in
The funds raised by banks are deployed under two major heads—loans &
advances, and investments. As of end-FY2003, loans & advances constituted
43.6% of the total assets of SCBs, while investments accounted for 40.8%. The
assets financed by the banks are linked to the liabilities through statutory
regulation, principal among which are the SLR and the CRR that mandate banks to
maintain a certain minimum proportion of their deposits in certain designated
liquid assets. The CAR also determines the nature (i.e., riskiness) and the quantum
of assets a bank can finance.

Advances by Indian banks, generally, take three forms—cash credit (CC), bills
purchased and discounted, and term loans. CC (49.8% of outstanding advances of
SCBs at end-FY2003) is the most popular mode of borrowing by business concerns
in India. The advantage of this mode is that the borrower does not need to borrow
the entire limit sanctioned at once. The borrower can withdraw only the amount
needed and return any surplus funds. When the customer requires temporary
accommodation, he may be allowed to overdraw his current account, usually
against collateral securities. While the overdraft is theoretically temporary, in
practice, bankers set regular limits for overdrafts also, in addition to the CC limit.
CC is generally given for a period of up to 12 months, with subsequent reviews.
Bill purchase and discounting (8.3% of outstanding advances at end-FY2003)
involves the financing of shortterm trade receivables through negotiable
instruments. These negotiable instruments can then be discounted with other banks
if required, providing the bank with liquidity. Term loans (41.9% of outstanding
advances at end-FY2003) are longer duration loans given typically for financing
projects, core working capital (WC) requirements, and normal capital expenditures.

The investments of banks are, primarily, in government securities in India (76.8%

of investments at end-FY2003). Banks in India, and especially PSBs, generally
hold government securities far in excess of their SLR requirements. Investments in
government securities benefit banks in the following ways. While the return is low,
the investments are virtually risk-free and there is no danger of generation of
 NPAs. Thus, government securities provide banks with a steady source of risk-free
income. Banks would naturally prefer to lend to the government at market-
determined rates than make `risky' loans to the private/corporate sector. Even
strong SCBs voluntarily invest in excess of SLR requirements in a bid to minimise
credit risk while increasing profitability. Such investments also do not entail
priority sector commitments, whereby a PSB has to set aside 40 paise for the
priority sector (priority sector requirements are detailed below) for every rupee that
it lends. Further, in an environment of declining interest rates, a fall in interest rates
results in an increase in prices of government securities. During the last three years,
SCBs have significantly improved their profitability by investing largely in
government securities, reaping trading gains with the declining yields and rising
prices. The system of fixed managerial compensation also discourages PSB
managers from taking risks. There is little incentive for officials of stateowned
banks to take additional risk. A failure or loss can lead to career damage, whereas
success may bring little reward. Thus, it is far easier to maintain a high proportion
of Government bonds with zero risk of default. Incentive and career structures in
PSBs do not encourage or reward dealing success. PSBs avoid any possible
investigation of their lending and any risk of default by investing in government
debt, both important considerations for their management in the current
environment.
Asset Profile of SCBs

Source: rbi.org/

The major elements of the reforms relate to the assets and liabilities side of the
balance sheet and are discussed in the following sections below.
 Liabilities
Liberalisation of Interest Rate on Deposits
Beginning 1992, a progressive approach was adopted towards deregulation of the
interest rate structure on deposits. The rates have been gradually freed, and at
present, the interest rate on term deposits have been completely deregulated. The
only administered interest rate is that on savings bank deposits, with a prescribed
interest rate of 3.5% per annum. The continued regulation of interest rates on
savings deposit (aggregating Rs. 3,023 billion or 22.3% of deposits at end-
FY2003) provides a degree of comfort to the PSBs since their margins are already
falling and deregulation is likely to spur added competition on the funding side.
While the PSBs have an advantage in funding costs on account of their vast branch
network, new private and foreign banks tend to incur lower operational costs.

Capital Adequacy
The RBI also adopted a strategy to introduce the attainment of CAR of 8% in a
phased manner was adopted. Based on the recommendations of the Committee on
Banking Sector Reforms, the minimum CAR was further raised to 9%, effective
March 31, 2000.
Phased Increase of CAR
(Percentage)
 Assets
Interest Rate on Loans and Advances
During 1975-76 to 1980-81, the RBI prescribed both the minimum lending rate
(13.5%) and the ceiling rate (19.5%). During 1981-82 to 1987-88, the RBI
prescribed only the ceiling rate, which was also progressively reduced to 16.5% in
1987-88. During 1988-89 to 1994-95, the RBI switched from a ceiling rate to a
minimum lending rate. The minimum lending rate, which was initially fixed at
16%, was increased to 19% in 1991-92, but, subsequently, lowered to 14% in
1993-94. After 1992, rates on priority lending were also allowed to be set more
freely. In October 1994, lending rates on loans exceeding Rs. 0.2 million were
freed. In April 1998, rates on loans under Rs. 0.2 million were also freed provided
they did not exceed the Prime Lending Rate (PLR) that the banks were allowed to
set. Banks are also allowed to offer loans at below-PLR rates to exporters or other
creditworthy borrowers, including public enterprises. Banks are now required to
announce the PLR and the maximum spread charged over the PLR. Currently,
interest rates are prescribed for only three categories of loans: first, for loans below
Rs. 0.2 million, interest rates cannot exceed the PLR: second, lending rates for
exports are prescribed: and third, ceilings are prescribed on certain advances in
foreign currency.

Reduced Cash Reserve and Statutory Liquidity Requirements

A major reform measure has been the gradual reduction in statutory pre-emptions
in the form of CRR and SLR requirements. CRR and SLR together aggregated
42% of deposits in the early 1980s, rising to 53.5% of deposits in 1990. This pre-
emption meant a decline in the share of deposits available for loans, even to the
priority sectors. The CRR has been progressively reduced from 15% in 1989 to
4.5%8 at present. Currently, SCBs are required to maintain with the RBI a CRR of
4.5% of the Net Demand and Time Liabilities (NDTL), excluding liabilities subject
to zero CRR prescriptions). The RBI has indicated that the CRR would ultimately
be reduced to the statutory minimum of 3%. However, with effect from the
 fortnight beginning November 3, 2001, all exemptions on the liabilities have been
withdrawn except inter -bank liabilities for computation of NDTL for the purpose
of maintenance of CRR. The SLR, which was at a peak of 38.5% during September
1990 to December 1992, has been reduced to the present statutory minimum of
25%.
These measures were designed to give greater discretion in the allocation of funds
to the SCBs and enable them to raise their profitability. The share of low interest
bearing cash and bank balances in total assets has declined from 16.6% at end-
FY1998 to 9.5% at end-FY2003. By increasing the quantum of investible funds in
the hands of banks, these measures also enhanced the need for efficient risk
management systems. While the reduction in CRR has resulted in an increase in
investible funds, the impact has been limited as the SCBs hold government
securities far in excess of the statutory minimum. SCBs' holding of government
and other approved securities aggregated 41.4% of their NDTL at end-December
2003. This has to be viewed in the context of the high level of fiscal deficit and
market borrowings by the government, which has the risk of crowding out bank
financing to the commercial sector. As the figure below shows, a large fraction of
bank deposits are being deployed for holding government securities. This ratio, as
is evident, has been increasing steadily over the last few years, and has persisted
even recently despite a strong economic recovery and, presumably, a consequent
increase in demand for credit.

Select Ratios of SCBs in India

Source: goidirectory.nic.in/
In deciding on a trade-off of lendable resources between increasing credit flows
and investing in government securities, the economic, regulatory and fiscal
environment favours the latter. Restricted commercial lending (arising from
structural changes in corporate resource raising patterns and multiple oversight
processes for PSBs), coupled with distortions in borrowing and lending structures
(including interest rate restrictions, the former artificially raising the cost of funds
for intermediaries and the latter relating to various PLR related guidelines for
SMEs and priority lending), have made treasury operations an important activity in
improving banks’ profitability. On the other hand, declining interest rates have
made holding government securities more profitable. There is also significant
potential of portfolio appreciation because of the trend of declining interest rates in
the economy. The system of fixed managerial compensation also discourages PSB
managers from taking risks.

Priority Sector Lending Requirement

Priority lending was a major aspect of `social banking’, and part of the mechanism
to set up cross subsidy from `free’ lending. The nationalisation of the banks
enabled the government to exert significantly greater pressure to lend to the
priority sectors. Post nationalisation, there were initially no specific targets fixed in
respect of priority sector lending. However, in November 1974, banks were
advised to raise the share of these sectors in their aggregate advances to 331/3% by
March 1979. In March 1980, the target was revised to 40% by March 1985. By the
1980s, about 55% of the funds available, after the CRR and SLR requirements,
were met (i.e., about 25% of deposits) went into priority and quasi-priority lending.
Beginning in the 1990s, the 40% (of net bank credit or NBC) priority sector
lending requirement (for PSBs and private sector banks) remained but its burden
was eased by freeing the rates on loans above Rs. 0.2 million 10, raising the rates
on small loans and making additional types of credit available11. The requirement
was increased to 32% for foreign banks in 1993. Thus, the priority sector has been
liberalised only to the extent that the interest rates have been liberalised and
additional types of credit have been made eligible. In fact, the share of priority
 sector advances in the gross bank credit of SCBs increased from 14% in June 1969
to 33% in March 2003. As of end-FY2003, all the bank groups had achieved their
priority sector lending targets.
Priority Sector Lending of SCBs
(Rs. billion)

High priority sector lending targets have been one of the major factors behind the
high NPAs of SCBs. While the share of priority sector lending in NBC is around
42.5% of PSBs, their share of NPAs was around 47.2% at end-FY2003.
Segment wise Distribution of NPAs at end-FY2003
(Rs. billion)

Asset Classification and Provisioning Norms

The prudential norms relating to asset classification have been tightened. The
earlier system of eight `health codes’ has been replaced by the classification of
assets into four categories:
Standard, Sub-standard, Doubtful, and Loss assets, in accordance with international
norms. The provisioning requirements of a minimum of 0.25% were introduced for
standard assets from the year ended March 31, 2000. The provisioning
requirements have also been prescribed for sub-standard, doubtful and loss asset
categories. The RBI has imposed a provision of 0.25% on standard assets; 10% on
sub-standard assets, 20-50% on doubtful assets (depending on the duration for
which the asset has remained doubtful), and 100% on loss assets.
The recognition of NPAs has also been gradually tightened, so that since March
2001, loans with interest and/or installment of principal remaining overdue for a
period of more than 180 days are classified as non-performing. The period has
been shortened to 90 days from the year ending March 31, 2004, but provisions are
required to be made from March 31, 2002. Banks have also been required to
progressively `mark-to-market’ their holdings of government securities.

Structural Reforms
Competition:
Since the initiation of banking sector reforms, a more competitive environment has
been created wherein banks are not only competing within the industry but also
with players outside the industry. While existing banks have been allowed greater
flexibility to expand their operations, new private sector banks have been allowed
entry. After the guidelines were issued in January 1993, nine new private sector
banks are in operation. Competition amongst PSBs has also intensified. PSBs are
now allowed to access the capital market to raise funds. This has diluted the
Government’s shareholding in them, although it remains the major shareholder in
PSBs, holding a minimum 51% of their total equity. Although competition in the
banking sector has been increasing in recent years, the dominance of the PSBs, and
especially of a few large banks, continues.
The PSBs are, thus, able to influence decisions about liquidity and rate variables in
the system. Although a significant decline in such concentration ratios is unlikely
in the near future, the PSBs are likely to face tougher competition, given the
gradual upgrade of skills and technologies in competing banks and the
restructuring and re-engineering processes being attempted by both private sector
and foreign banks. Moreover, banks are also facing stiff competition from other
players like non-bank finance companies, and mutual funds (MFs).

Government Ownership and Management of PSBs

Though the government has allowed equity dilution of its stake in nationalised
banks, it has not ceded management control. Equity dilution has largely been a
capital raising exercise, without greater non -governmental shareholder
supervision. Individual voting rights, the key instrument of shareholder
participation, are still limited by rules to a maximum of 10% of the total voting
rights of all the shareholders of the banking company13. Nationalized banks are
accountable to the Indian Parliament. Key appointments and policies have to be
vetted by government. As long as shareholders are denied full voting rights, and
are placed at par with government, there seems little or no scope for effective
transition to market discipline. Little effort has also been made to encourage sound
bank management practices through a system of incentives, nor are there
significant disincentives. Top management salaries in the nationalized banks
continue to be pegged to salaries at comparable levels in government. The system
of employee wage negotiations cutting across the banking industry without
reference to either the health or the paying ability of individual banks means that
employees or management have little stake in the health of the bank. Even if the
government stake falls to 33%, as long as banks are covered under the definition of
State under the Indian Constitution, there seems to be little to no flexibility on the
human resource issue. To examine the relationship between Government
ownership and performance, the RBI recently compared the performance of banks
based on select parameters at two levels: (a) comparison of a representative sample
of five PSBs which divested their Government holding early in the reform process
with a representative sample of five wholly government-owned PSBs, and (b)
comparison of the aforesaid two categories with old private sector banks as a
group.

The findings for the period FY1996 to FY2002 indicate:

• PSBs wholly owned by the GoI had the highest ratio of operating expenses
to total assets.
• Interest spread (net interest income to total assets) of wholly government-
owned PSBs was lower than divested PSBs during each of the seven years,
but generally higher than old private sector banks.
• Profitability (ratio of net profit to total assets), on an average, was the
lowest for wholly government owned PSBs. However, the gap narrowed
down significantly from FY1999 onwards.
• Asset impairment (ratio of gross NPAs to gross advances) during each of
 the years under reference in respect of wholly-government owned PSBs
was the highest.
• The CAR of wholly-government owned PSBs was the lowest. However,
their CAR has improved over the years.
• Banks’ Entry into Insurance With the enactment of the Insurance
Regulatory and Development Authority (IRDA) Act, 1999, banks and
NBFCs have been permitted to enter the insurance business. The RBI has
issued the final guidelines for banks’ entry into insurance business. For
banks, prior approval of the RBI is required to enter into the insurance
business. The RBI would give permission to banks on a case-by-case basis,
keeping in view all relevant factors. Banks having a minimum net worth of
Rs. 5 billion and, satisfying other criteria in respect of capital adequacy,
profitability, NPA level and track record of existing subsidiaries, can
undertake insurance business through joint ventures, subject to certain
safeguards. The maximum equity contribution such a bank can hold in the
joint venture company will normally be 50% of the paid-up capital of the
insurance company. On a selective basis, the RBI may permit a higher
equity contribution by a promoter bank initially, pending divestment of
equity within the prescribed period. Banks which are not eligible as joint
venture participants, as above, can make investments up to 10% of the net
worth of the bank or Rs. 0.5 billion, whichever is lower, in the insurance
company for providing infrastructure and services support. Such
participation shall be treated as an investment and should be without any
contingent liability for the bank. Banks are also now allowed to undertake
referral arrangements with insurance companies, through their network of
branches, subject to certain conditions to protect the interests of their
customers. Under the referral arrangement, banks provide physical
infrastructure within their select branch premises to insurance companies
for selling their insurance products to the banks' customers with adequate
disclosure and transparency and, in turn, earn referral fees on the basis of
premia collected.
 At present, amongst the PSBs, the SBI has floated a life-insurance subsidiary.
During FY2003, seventeen PSBs, 9 private sector banks, one foreign bank, and
a subsidiary of a private sector bank were given 'in principle' approval by the
RBI for acting as corporate agents of insurance companies to undertake
distribution of insurance products on non-risk participation basis.

IMPACT OF REFORMS ON BANKS

To gauge the effects of reforms on the banking industry, it is imperative to view
the reforms over a period of time. When the reform process was launched in 1991,
the banking sector received a jolt. Implementation of uniform and transparent
accounting practices exposed the fragility in the system in terms of the bad loan
problem and lack of profitability.

Profits

Till the adoption of the prudential norms, 26 out of 27 PSBs were reporting profits.
In the first post-reform year, i.e., FY1993, the combined profitability of the PSBs
turned negative with a net loss of Rs. 32.93 billion during FY1993, with as many
as 12 nationalised banks reporting net losses. However, subsequently, there has
been a significant improvement. The PSBs reported a net profit of Rs. 11.16 billion
during FY1995, compared with a net loss of Rs. 43.49 billion in FY1994. In recent
years, the net profits of PSBs increased 48% during FY2003 to Rs. 122.94 billion
during FY2003, as compared with a growth of 92.5% during FY2002. However,
net profits of PSBs declined 15.7% during FY2001, mainly because of voluntary
retirement scheme (VRS) expenses12. All the twenty-seven PSBs reported net
profits during FY2003 and FY2002, as compared with 25 during FY2001, and 19
during FY1996. The net profits of all SCBs have also increased from Rs. 19.60
billion in FY1996 to Rs. 170.68 billion during FY2003 (refer Table below). Net
profits, as per cent of average assets, have increased significantly from 0.53% in
FY1999 to 1.06% in FY2003.
 Net Profits of SCBs in India
(Rs. billion)

Capital Adequacy
As of end-FY1993, only one PSB had a CAR of above 8%. The equity capital of
the PSBs has been rising steadily after the reforms—from Rs. 30.34 billion at end-
FY1991 to Rs. 141.75 billion at end-FY2003. By end-FY1996, the outer time limit
for attaining capital adequacy of 8%, eight PSBs were still below the prescribed
level. Since then, the CAR has improved for all major categories of banks. Overall
CAR of the banking sector has improved significantly from 10.4% at end-FY1997
to 12% at end-FY2002, and to 12.6% at end-FY2003. At-end FY2003, the CAR of
91 out of 93 SCBs exceeded the stipulated minimum of 9%; only 2 NPBs had CAR
below the stipulated minimum of 9%.

Distribution of SCBs by CAR

A key factor in the quick improvement in the CAR of PSBs is that the GoI owns a
majority stake. Thus, the GoI did not need to resort to complicated procedures
observed in the rehabilitation process of banks in Korea and Japan, to inject funds
into major banks. Till FY2003, the government had injected Rs. 230 billion
towards recapitalisation of 19 nationalised banks.
Deposit Growth
The deposits of the banks have also increased over the years. After the securities
scam of 1992, bank deposit mobilisation increased, as a greater part of the
 household sector savings started to move from the stock markets to the banking
sector. Over the last decade, the deposits of all SCBs increased 4.6 times—from
Rs. 2,619 billion at end-FY1992 to 13,559 billion at end-FY2003. Deposits
increased at a compounded annual growth rate (CAGR) of 16.1% between FY1999
and FY2003, as compared with 5.4% between FY1993 and FY1997. As indicated
in figure below, overall efficiency of the banking sector (as measured by deposits
as a percentage of GDP) has also increased.

SCB’s deposits as a percentage of GDP

Source: rbi.org/

Asset Quality and Non-Performing Loans

The position on the asset quality front has also improved over the last few years.
Net NPAs, as percentage of net advances of all SCBs, has declined from 8.1% at
end-FY1997 to 4.3% at end-FY2003. During FY2003, there was also an absolute
decline in the NPAs of SCBs. Gross NPAs declined Rs. 21.47 billion during
FY2003, as compared with an increase of Rs. 71.20 billion during FY2002.
Amongst the bank categories, three of the eight SBI & associate banks had net
NPA to net advances exceeding 10% at end-FY1997. Their number declined to just
one at end-FY2000, and nil thereafter. The number of nationalised banks having
NPAs exceeding 10% also declined from seven at end-FY1997 to three at end-
FY2002, and two at end-FY2003. In the case of old private sector banks, this
number declined from three to two over the same period. None of the new Indian
private sector banks had net NPAs exceeding 10% during FY1997 to FY2002;
however there was one new Indian private sector banks with net NPAs exceeding
 10% at end-FY2003. In the case of foreign banks operating in India, the number of
banks with NPAs/net advances exceeding 10% increased from three at end-
FY1997 to 14 at end-FY2002, before declining to 8 at end-FY2003.

Frequency distribution of Net NPAs to Net Advances—SCBs

While as a percentage of advances, the net NPAs have come down, in absolute
terms, net NPAs had increased from Rs. 277.74 billion at end-FY1997 to Rs.
355.54 billion at end- FY2002. Similarly, while gross NPAs/gross advances have
declined from 15.7% at end- FY1997 to 8.8% at end-FY2002, the gross NPAs of
the SCBs increased from Rs. 473 billion at end-FY1997 to Rs. 687.14 billion at
end-FY2003. However, during FY2003, recoveries of NPAs outpaced additions
resulting in a decline in both gross and net NPAs.
Since 1993, the growth of NPAs has been held below asset growth, even while
interest rates have been liberalised. At the same time, provisioning has increased,
so that the gross NPAs, as per cent of assets, have declined from 7% at end-
FY1997 to 4% at end-FY2003; net NPAs, as per cent of assets, have also declined
from 3.3% at end-FY1997 to 1.9% at end-FY2003. In terms of credit allocations,
banks’ investments in government securities, which earlier formed a major part of
credit allocations, have been nearly unaffected by the liberalisation. Including the
reduced CRR requirements, SCB’s cash balances with the RBI; and investments in
India in government & approved securities aggregated 37.6% of assets at end-
FY2003. During FY1998-2003, the growth in SCBs’ investment in government
securities exceeded the growth in assets. During FY2004, while aggregate deposits
of SCBs in India increased 17.3%, investments in government and approved
securities increased 24.1%; bank credit increased 14.6%. As discussed, government
debt is an attractive instrument with its higher market-based rates and minimal
limited capital requirement (zero until the increase in risk weighting to 2.5% in
1998). PSBs also avoid any possible investigation of their lending and any risk of
default by investing in government debt, both important considerations for their
management in the current environment.
A decade after financial sector liberalisation, although there has been a significant
improvement in the banking industry performance, there has been little concerted
effort at restructuring the PSBs. As a consequence, profitability and viability of the
PSBs are still below global standards and even the average values within the Indian
banking industry. Intermediation costs are high, resulting in high nominal lending
interest rates. The fact that there have been no instances of systemic crises,
contagion, bank closures, bank runs, bank nationalisation post-liberalization,
should not divert attention from the problems of high and unresolved NPAs,
inadequate management skills, and relatively volatile operating performance.

BANKING INDUSTRY PERFORMANCE

While carrying out a time-scale performance analysis of the Indian banking sector,
it is important to keep in mind the perceptible impact that the phased
nationalization has had on the structure and performance of the Indian banking
sector. The nationalization of the banking sector was an endeavor by the Central
Government to achieve geographical expansion and increase directed lending to
the priority sectors, including agriculture and small-scale industries. The
nationalisation was successful, to a large extent, in meeting the social objectives of
the government. The total branch network of commercial banks increased more
than eight-fold from 8,262 branches in 1969 to 68,561 in March 2003. During the
same period, the growth in advances to the priority sector, including agriculture
and small-scale industries outstripped the growth in aggregate credit. As a result,
the ratio of priority sector credit to total credit by SCBs increased from 14% in
June 1969 to 33% by end-March 2003.
The following discussion will analyse the financial performance of the Indian
banking industry against the following parameters:
  Income;
 Yields;
 Interest Costs;
 Spreads;
 Intermediation Costs;
 Profitability;
 Return On Assets;
 Capital Adequacy; And
 Asset Quality.

Income
The total income of all SCBs in India increased 14% during FY2003 to Rs. 1,724
billion, compared with a growth of 14.5% during FY2002, and 14.5% during
FY2001. While interest income increased 10.7% during FY2003 (10.4% during
FY2002) to Rs. 1,407 billion, other income increased 31.2% during FY2003
(42.1% during FY2002) to Rs. 317 billion. Interest income has declined from
87.1% of income during FY2001 to 84% of income during FY2002, and to 81.6%
of income during FY2003.
During FY2003, the income of PSBs increased 9.6% to Rs. 1,285 billion,
compared with a growth of 13.3% in FY2002. Their dominance in the banking
sector is attested by their consistent share of 78% to 79% of income of all SCBs
during FY1998-FY2002. However, because of the ICICI merger, the PSBs share of
total income declined to 74.5% during FY2003. Because of the merger, the NPBs
recorded the highest increase in income of 104.7% during FY2003, followed by
OPBs (3%). The foreign banks recorded an income decline of 7.1% during
FY2003, caused by declining interest rates, and a reduction in the number of
foreign banks operational.

Income Trends and Growth Rate

(Rs. billion)
 (10.7)
Interest income, which constituted 81.6% of income during FY2003, increased
10.7% during FY2003, compared with 10.4% during FY2002. The growth in
interest income was led by a healthy growth in advances and investments, rather
than yields (which declined). Domestic advances and investments of SCBs
increased 16.6% during FY2003 to Rs. 13,810 billion (refer Table below),
compared with a growth of 21.5% during FY2002, and 18.5% during FY2001.
Overall advances and investments increased 16.2% during FY2003 to Rs. 14,343
billion, as compared with a growth of 21.2% during FY2002, and 18.5% during
FY2001. A recent study by the RBI on finances of selected 997 non-Government,
non -financial large public limited companies has indicated that while incremental
borrowings from banks increased from Rs. 55.85 billion in FY2002 to Rs. 63.99
billion in FY2003, the share of incremental bank borrowings in external funds
decreased from 65.1% to 53.6%. However, the share of external sources of funds
such as issues of equity and trade creditors increased during FY2003.

SCBs—Advances/Investments and Growth

Non-interest (or other) income of SCBs increased 31.2% during FY2003 to Rs.
 316.56 billion, compared with a growth of 42.1% during FY2002 and 6.6% during
FY2001. The other income mainly consisted of profit on sale of investments
(45.1% of non -interest income), commission, exchange & brokerage (33.4%), and
profit on exchange transactions (8.9%). Other income has increased substantially
during the last two years because of the substantial profits on the sale of
investments—net profit from sale/revaluation of investments increased from Rs.
30.26 billion in FY2001 to Rs. 93.41 billion in FY2002, and to Rs. 142.62 billion
in FY2003. Banks have been able to report significant capital gains on account of
the downward movement of interest rates. With their substantial holding of
Government securities, SCBs have profited from a significant decline in yields on
government securities. Net profit from sale/revaluation of investments as a percent
of aggregate net profits has increased from 18.7% in FY1999 to 80.8% during
FY2002, and 83.6% during FY2003. Yields have declined because of the excess
liquid funds of commercial banks flowing into the Government securities market.
During FY2003, yield on 10-year Government securities declined by 115 basis
points to 6.21% at end-March 2003. During FY2004, due to the reduction of the
repo rate by 50 basis points from 5% to 4.5% from August 25, 2003, there was a
sharp decline in the yields and the 10-year yield touched a historic low of 5.23%.
The 10-year yield reached a further low of 4.95% on October 16, 2003. However,
the markets stabilised in view of the RBI's low inflation outlook and reiteration of
the soft interest rate stance. The benchmark 10-year yield declined to 5.14% at end-
March 2004. Even after significant sale of higher-interest Government securities,
SCBs continue to hold a high proportion of higher -interest government securities.
As the table below shows, nearly 70% of the SCBs outstanding investments in
central and state government securities at end- FY2003 carried an annual interest
rate exceeding 10%. Further, an estimated 23% of these securities at end-FY2003
(29.3% at end-FY2002) carried an annual interest rate exceeding 12%.

Interest Rate Distribution of SCBs investments in central and state

government securities
(Percentage of total)
Less than 6% 6-8% 8-10% Over 10%
 Income from commission, exchange and brokerage is another major source of non-
interest income, accounting for 6.1% of income of SCBs during FY2003. Such
income is mainly earned from off-balance sheet activities such as forward
exchange contracts, guarantees, acceptances, and endorsements. Income from
commission, exchange and brokerage increased 14.7% during FY2003 to Rs.
105.70 billion, mainly because of a 31.4% increase in contingent liabilities to Rs.
11,642 billion. Foreign banks are very active in derivatives, with the exposure of
foreign banks in forward currency contracts increasing from Rs. 3,609 billion at
end-FY2002 (57.3% of forex exposures of all SCBs) to Rs. 4,172 billion at end-
FY2003 (54.7% of forex exposures of all SCBs). Contingent liabilities represented
68.5% of liabilities of SCBs at end-FY2003, as compared with 57.7% at end-
FY2002.

Contingent liabilities and income from commission, brokerage and exchange of

SCBs

Contingent

As discussed below, the growth in income lagged the growth in average assets,
which increased 14.3% during FY2003, compared with a growth of 17.7% during
FY2002, and 16.7% during FY2001. As a result, yields have declined over the past
few years. Interest earned, as per cent of average assets, declined from 10% during
FY1999 to 8.70% during FY2003. However, non-interest incom e, as per cent of
average assets, increased from 1.46% during FY1999 to 1.96% during FY2003.
The increase in non -interest income (because of trading profits from interest rates
declines) has partially offset the decline in income from advances and investments
(because of interest rate declines). Total income, as percent of average assets, has
declined by 80 basis points—from 11.46% during FY1999 to 10.66% during
FY2003. Because of the merger of ICICI and ICICI Bank, the figures for FY2002
are underestimates. However, the decline in yields has been accompanied by a
decline in cost of deposits.

Interest and Non-Interest Income of SCBs

As can be seen from the above table, foreign banks report a substantially higher
non-interest income (as percent of average assets). Foreign banks are the most
active in off-balance sheet activities. Their contingent liabilities aggregated 482.8%
of liabilities at end-FY2003, and income from commission, exchange and
brokerage accounted for 11.5% of income of foreign banks during FY2003.

Yields
For all SCBs, income from advances, which constituted 39.8% of income of SCBs
during FY2003, increased 15.3% during FY2003 to Rs. 686.36 billion, compared
with a growth of 7.5% during FY2002, and 16.6% during FY2001. By comparison,
advances increased 14.5% during FY2003 to Rs. 7,405 billion, compared with a
growth of 22.9% during FY2002, and 18.1% during FY2001. The growth in
income from advances outpaced the growth in average advances, mainly because
of the full inclusion of income for FY2003 of merged ICICI Bank as compared
with 2 days inclusion for FY2002). However, yields on average advances have
been declining because of the decline in interest rates in the Indian economy. The
 yield on average advances for all SCBs has declined from 12.34% in FY1999 to
9.90% in FY2003. The PLR of PSBs declined from 10-13% in March 2001 to
9.75-12.25% in December 2003. On balance, PLRs were lower as at end-FY2003
than the corresponding levels as at end-FY2002 for the three groups of SCBs. The
following Table sets forth the decline in PLR for the last few years.
Trends in PLR of SCBs
(Percent per annum)

Source: RBI, Source: rbi.org/

Interest/dividend income from investments, which constituted 36.2% of SCBs

income during FY2003, increased 8.9% during FY2003 to Rs. 623.59 billion,
compared with a growth of 13.8% during FY2002, and 14.4% during FY2001. By
comparison, investments increased 18.1% during FY2003 to Rs. 6,938 billion,
compared with a growth of 19.5% during FY2002, and 18.9% during FY2001.
However, as with advances, the growth in investment income lagged the growth in
average investments, which increased 18.7% during FY2003, compared with
19.2% in FY2002, and 20.2% in FY2001. The yield on average investments for all
SCBs increased from 11.89% in FY1999 to 9.73% in FY2003. The decline in yield
was because of revised provisioning norms, high investment in India in
government and approved securities, and a decline in yield on government
securities. The monetary and credit policy for the second half of FY2001,
announced in October 2001, had resulted in introduction of a significant change in
bank’s valuation of investments. Investments are now to be classified into three
categories—held to maturity (HTM), available for sale (AFS), and held for trading
(HFT). At end-FY2003, SCBs investments AFS accounted for 75.4% of
investments, followed by HTM (20.2%), and HFT (4.2%). The HTM category
securities need not be marked to market and cannot exceed 25% of the portfolio.
Earlier, the RBI had stipulated that banks must mark to market at least 70% of the
portfolio. Many banks had, however, marked 100% of the portfolio to the market
to take advantage of the declining interest rates. The decline in yield on
 investments has also been because of increased investment in domestic government
securities. Incremental investments in domestic government and approved
securities accounted for 96.2% of incremental investments of SCBs during
FY2003, compared with 79.1% during FY2002. Higher investments in government
securities was also accompanied by a decline in yields on government securities
over the past few years.

Average Yield levels on Govt. securities

(Per cent per annum)

A positive impact of the declining interest rates was an appreciation in prices of

securities resulting in a 52.7% increase in net profit from sale/revaluation of
investments during FY2003. Including such profits, yield on average investments
declined from 12.34% during FY2002 (11.79% during FY2001) to 11.96% during
FY2003. Interest income on balances with RBI and interbank funds, which
constituted 3.9% of SCBs income during FY2003, declined 14.4% during FY2003
to Rs. 67.99 billion, compared with a growth of 23.2% during FY2002, and 18.1%
during FY2001. Such income declined because of a 21.7% decline in cash and
bank balances to Rs. 1,607 billion at end-FY2003, caused by lower CRR.
However, income on such balances has been boosted because of an increase in the
interest rate payable on eligible cash balances maintained with RBI. The annual
interest rate was increased from 4% to 6% (from the fortnight beginning April 21,
2001). With effect from the fortnight beginning November 3, 2001, the interest
paid on eligible cash balances was at the Bank Rate. However, average call money
rates declined from 6.58% in April 2002 to 5.86% in March 2003, and to 4.40% in
December 2003. Overall, the yield on cash and bank balances increased from
4.01% during FY2002 to 3.72% during FY2003.
CRR Movements—FY1999 to FY2004
Per cent (effective date)

Overall, the decline in yields on advances and investments has resulted in a

decline in yield on average interest bearing assets of SCBs, which declined from
10.87% in FY1999 to 9.27% in FY2003 (refer Table below).
Yield Indicators of SCBs
(Per cent per annum)

.40% 9.73%
Source: banknetindia.com/

Another reason for the falling yields is the focus of banks on highly rated clients.
Faced with high NPA levels, banks are concentrating on safer clients who cannot
be charged high riskpremiums. Further, a higher proportion of assistance now takes
the form of CP, bonds and debentures. In the present situation of easy liquidity,
banks prefer investing in CPs, as they can deploy funds at interest rates higher than
call rates, and also avoid the higher transaction costs associated with bank loans. In
return for the higher liquidity they offer, these instruments are issued at lower
interest rates. 2.85 The discount rates on CP declined from a range of 6-7.75%
during end-March 2003 to 4.7-6.5% by end-March 2004. CP has now emerged as
an important source of funding WC needs; however, it is restricted to a few large
companies with healthy credit ratings and does not enjoy wider market
acceptability. Further, SCBs investments in CP have declined in recent years
because of a decline in primary issuances by manufacturing companies having
access to sub-PLR lending.
 SCBs investments in CP, Shares, Bonds, Debentures, etc
(Rs. billion)

Interest Cost
Although all categories of SCBs have experienced a decline in yields on average
interest bearing assets, the decline has been accompanied by a decline in cost of
funds. Interest expended, which accounted for 54.3% of SCBs income during
FY200314, increased 6.9% during FY2003 to Rs. 936.07 billion, compared with a
growth of 12.1% during FY2002, and 12.7% during FY2001. The cost of deposits
constituted 88.3% of interest expended during FY2003, and increased 2.5% during
FY2003, compared with a growth of 12.3% during FY2002, and 11.8% during
FY2001. By comparison, deposits increased 12.7% during FY2003 to Rs. 13,559
billion, compared with a growth of 14% during FY2002, and 17.2% during
FY2001. Deposit mobilisation was higher during FY2001 because of Rs. 257
billion raised through India Millenium Deposits (IMD).
Over the last few years, the cost of deposits, and the cost of average interest
bearing funds has declined because of softening of interest rates in the economy.
The decline in interest rates is in consonance with the monetary policy stance of a
soft and a flexible interest rate regime. Bank rates have been reduced significantly
over the years (refer Table below). The reduction in bank rates acts as a signalling
device for a lower interest rate regime. However, the average lending rates of
banks continue to be substantially higher than the Bank Rate.
Thus, the relation between lending rates and Bank rate is now relatively weak.
Bank Rate Movements during FY1999 to FY2004
Per cent per annum (effective date)

The spreads of lending rates of commercial banks over their average costs of
 deposits reveal a marginal narrowing down FY1997. The RBI has noted that the
stickiness in the interest rate structure of commercial banks is because of a number
of reasons:
 Average cost of deposits for major banks continues to be relatively high,
because of the high returns on alternative savings instruments. Despite
reductions in the administered interest rates on small savings and provident
funds in recent years, they yield higher returns than bank deposits. This
constrains the ability of banks to reduce deposit rates.
 Longer-duration term deposits at fixed interest rates constitute a substantial
portion of bank deposits, thereby limiting the flexibility to reduce lending
rates in the short-term.
 High NPAs increase the average cost of funds for banks.
 High non -interest operating expenses of banks reduce the flexibility to
reduce interest rates.
 In view of legal constraints and procedural bottlenecks in recovery of dues
by banks, the risk premium tends to be higher resulting in a wider spread
between deposit rates and lending rates.
 The large borrowing programme of the Government, over and above SLR
requirements, gives an upward bias to the interest rate structure.
The deposit rates have been gradually freed from regulation, and, at present, the
only administered interest rate is that on savings bank deposits. The prescribed rate
of interest on savings deposits is 3.5% per annum. The average term deposit rates
have also declined.

Trends in Domestic Deposit Rates of SCBs

(Per cent per annum)

In tune with the trend of declining interest rates over the past few years, the
average cost of deposits for SCBs declined from 8.05% in FY1999 to 6.46% in
FY2003. The cost of average deposits also declined significantly during FY2003
 because of lower growth in term deposits (because of lower accrual of interest in
view of declining interest rates, and a shift to current accounts in consonance with
higher industrial activity), and a shift in maturity structure of deposits towards
lower -cost lower-duration deposits.

Maturity Pattern of Deposits of SCBs

(% of deposits)

goidirectory.nic.in/

The cost of average interest bearing funds has also declined from 8.23% in FY1999
to 6.80% in FY2003. Various policy measures over the years have, thereby,
resulted in lower average cost of interest bearing funds for SCBs (refer Table
below).

Cost of Deposits and Interest Bearing Funds of SCBs

Spreads
Over the past few years, although the yield on average earning assets has declined
for SCBs, the decline has been partially offset through a decline in cost of average
interest bearing funds. However, the gross interest spread (yield on average earning
assets minus the cost of average interest bearing funds) declined from 2.64% in
FY1999 to 2.47% in FY2003. Another indicator of spreads—net interest income as
a percentage of average assets—also declined from 3.02% to 2.91% over the same
period.
 Spread Indicators of SCBs
(Per cent of average assets)

However, a distinguishing feature of SCBs performance during FY2003 was the

increase in gross spreads. The increase in spreads in FY2003 was caused by the
larger fall in cost of funds compared with the yields. One reason is the lower
deployment of cash balances because of CRR cuts. Another reason for the increase
in spreads during FY2003 is the assetliability maturity profile of banks. As of end-
FY2003, SCBs term deposits constituted 65.6% of deposits, and 52.3% of liabilities.
Term deposits carry a higher interest rate than savings deposits, and the interest rate
on term deposits is, usually, directly related to duration. Nearly all major SCBs
reported a shift in maturity structure of deposits, with an increased proportion of
shorter duration deposits during FY2003. In terms of maturity pattern, deposits of
SCBs with a maturity upto 1-year increased from 34.3% of deposits at end-FY2002
to 37.8% at end-FY2003. Such deposits increased 24.3% during FY2003. By
comparison, the share of deposits with maturity exceeding 1 year declined from
65.7% to 62.2%. Such deposits increased only 6.7% during FY2003, with most of
the increase accounted for by deposits with a maturity exceeding 5 years. The shift
in maturity structure of deposits has benefited banks and provided them more
flexibility in responding to interest rate declines.
The increase in spreads has been accompanied with a significant improvement in
oninterest income. As a result, net operating income, as percent of average assets,
increased from 4.50% in FY2002 to 4.87% in FY2003. Further, the figure was
higher than 4.48% in FY1999. Foreign banks enjoy the highest spreads in India,
primarily because of high gross spreads, and significant off-balance sheet activities.
Over the last few years, while SCBs have reduced their PLRs and are now also
 extending sub-PLR loans, effective lending rates remain high. It is estimated that the
average lending rate of scheduled commercial banks has declined from a peak of
17.1% during FY1996 to 13.9% during FY2002. However, real interest rates have
not declined in the same magnitude. As a result, the effective real lending rate
continues to remain high.

Real Interest Rates

(Percent per annum)

Intermediation Costs
The intermediation cost (operating expenses to average total assets) of SCBs showed
a significant decline from 2.84% in FY2001 to 2.38% in FY2002, and to 2.35% in
FY2003. This followed a significant increase during FY2001—from 2.68% in
FY2000. Intermediation costs increased 12.9% during FY2003 to Rs. 380.88 billion,
compared with a decline of 1.3% during FY2002, and increase of 23.8% during
FY2001. Employee expenses constitute the largest proportion of intermediation
costs. However, their share of intermediation costs declined from 68% during
FY2001 to 62.1% during FY2003, mainly because of a significant decline in
employee strength for PSBs. Over the period FY2001-03, the decline in employee
expenses for PSBs has been the primary factor behind the significant decline in
intermediation costs (as percent of average assets). Employee expenses, as percent of
average assets, declined from 1.93% during FY2001 to 1.54% during FY2002, and
to 1.46% during FY2003. Employee expenses represented 13.7% of income during
FY2003, compared with 14.4% during FY2002, and 17.6% during FY2001. The
combined employee strength of all SCBs declined an estimated 0.7% during
FY2003, as compared with declines of 3.4% during FY2002, 8.1% during FY2001,
and 1.1% during FY2000. The combined employee strength of SCBs aggregated
0.839 million at end-FY2003.
 Staff Strength at SCBs
(Thousands)

The SCBs had manpower strength of 0.951 million at end-FY2000, of which PSBs
accounted for nearly 92%. PSBs accounted for almost all the decline in
intermediation costs during FY2002 and FY2003, and nearly all the increase in
intermediation costs during FY2001. During FY2001, 26 out of 27 PSBs (with the
exception of Corporation Bank) implemented a voluntary retirement scheme (VRS)
for their employees. As a result, their employee strength declined 8.7% during
FY2001 to 0.80 million. Employee strength of PSBs declined an additional 5.1%
during FY2002, and 0.2% during FY2003 to 0.755 million at end-FY2003. By end-
FY2003, PSBs had implemented employee reductions of approximately 13.5% of
their end-FY2000 levels. The cost of VRS was estimated at Rs. 123 billion. In
accordance with the RBI guidelines, PSBs charged an amount of Rs. 23.29 billion
during FY2003 (Rs. 30.07 billion during FY2001 and Rs. 23.46 billion during
FY2002) on their income statement on account of VRS. The balance amount of Rs.
46.18 billion at end-FY2003 will be written off during FY2004-05. Excluding VRS
amortisation, employee expenses of PSBs increased 8.5% during FY2003, as
compared with a decline of 6.9% during FY2002, reflecting lower employee strength
The significant decline in employee strength of PSBs has resulted in a significant
decline in their intermediation cost (operating expenses to average total assets)—
from 2.71% during FY2000 to 2.37% during FY2003. Excluding VRS amortisation,
intermediation costs of PSBs as a percent of average assets aggregated 2.18% during
FY2003.
The wage bill, as percent of income, of NPBs and foreign banks is significantly
lower than PSBs. In FY2003, the employee expenses of the NPBs, as a share of
operating expenses, was merely 21.9% as compared with 31.9% for foreign banks,
60.4% for OPBs, 70.7% for the nationalised banks, and 71.1% for the SBI &
associate banks. This reflects the higher level of application of technology in these
 banks and the lack of a historical legacy of excess staffing. The OPBs and the PSBs,
in fact, share many common traits: a public sector ethos, excess staffing and
considerable NPAs.
Intermediation Cost Indicators of SCBs
(Percent of average assets)

2.35% 2.38% 8
Source: goidirectory.nic.in/

In terms of an important indicator of efficiency—the cost to income ratio (defined as

operating expenses as a proportion of net operating income)—although the PSBs
have reported a significant improvement in efficiency, i.e., a decline in cost-income
ratio, they still lag behind the NPBs and foreign banks. A high cost-income ratio for
PSBs has reduced the flexibility of PSBs to respond to interest rate cuts, and has
acted as a drag on profitability.
Cost-Income Ratios of SCBs

Source: eximkey.com

The staff strength per unit of business is higher in almost all the PSBs than in the
OPBs and substantially more than in the NPBs or the foreign banks. Although PSBs
have the least staff expenses per employee (Rs. 0.282 million during FY2003), their
business per employee (BPE) lags. Although the decline in employee strength of
PSBs during the last three years has resulted in a significant increase in employee
productivity, it still lags the productivity indicators of NPBs and foreign banks.
During FY2003, each employee of a foreign bank contributed Rs. 10.1 million
 towards income. By contrast, income per employee was Rs. 8.5 million for NPBs,
Rs. 2.4 million for OPBs, Rs. 1.7 million for SBI & associates and Rs. 1.7 million
for nationalised banks (refer Table below).
Per Employee Productivity Indicators of SCBs
(Rs. in thousand)

It can be seen that employee productivity is highest for foreign banks followed by
NPBs. During FY2003, only three PSBs—Corporation Bank, Oriental Bank of
Commerce, and State Bank of Indore—had a profit per employee figure of over Rs.
0.3 million. By comparison, many foreign banks and NPBs report per employee net
profits of over Rs. 1 million. The nationalised banks have the lowest employee
productivity. This is consistent with their larger rural presence, and the fact that the
NPBs started operations in the 1990s with an optimal mix of labour and
technology. In fact, use of technology was one of their unique selling points to the
new generation of Indian businesses and individuals in the post-reform era. By
end-March 2000, new private sector banks and foreign banks had connected almost
all of their branches with networks. Rather than expansion through full-fledged
branches, these category of banks have placed increased focus on automated teller
machine (ATM) branches, thereby reducing employee costs.
The poor profit generation capability of the PSBs is not the sole reason for such
dismal performance. Abnormally high workforces and their resistance to
technological advancements are some of the other drawbacks. Computerisation and
automation of transactions is likely to result in a fall in demand for clerical
personnel. Since the PSBs have a higher number of clerical employees, there is
resistance to computerisation. Following the order by the Central Vigilance
Commissioner to computerise 70% of the total banking business in India by
 January 2001, the computerisation drive has gained momentum in the PSBs. As at
end-FY2002, an estimated 82% of the branches of PSBs were fully or partly
computerised, accounting for around 78% of total business. The financial
performance and levels of service of NPBs have set the pace for PSBs. Some
progress has been made in the absorption of technology in PSBs. But without a
reduction in surplus labour, these banks have focused on inducting technology only
in metropolitan areas or in larger branches in non-metro areas, where competitive
pressures are intense. However, non-priority branches (which form the bulk) are
not getting management attention and investments. These branches are stagnating,
and contributing little if any to profits.

Profitability
Because of a significant decline in intermediation costs and sharp increase in other
income, the operating profits of SCBs have increased significantly in recent years.
Operating profits increased 36% during FY2003 to Rs. 406.80 billion, as compared
with increases of 51.5% during FY2002, and 6.9% during FY2001. Operating
profits, as percent of average assets, improved significantly from 1.64% during
FY2001 to 2.51% during FY2003.
Operating Profits of SCBs

2.51% 2.11%
Source: rbi.org/

Despite a 28.6% increase in provisions and contingencies (P&C) during FY2003 to

Rs. 236.12 billion, the net profit of all SCBs increased 47.6% during FY2003 to
Rs. 170.68 billion, compared with a growth of 77.7% during FY2002, and decline
of 11.8% during FY2001.

Net Profits of SCBs

During FY2003, inspite of an increase in P&C, net profits increased significantly
because of improvements in net interest margin and other income. All the bank
groups reported significant growth in net profits during FY2003. The increase was
67.5% for private sector banks, 48% for PSBs, and 21.8% for foreign banks.
Provisions for NPAs and taxes increased significantly during FY2003, reflecting
higher operating profits and gradual tightening of prudential norms. P&C, as
percent of average assets, increased from 1.30% during FY2002 to 1.46% during
FY2003.

Return on Assets
The return on assets (RoA) of all SCBs has almost doubled in two years—from
0.54% in FY2001 to 1.06% in FY2003, mainly because of a sharp increase in net
profit from sale/revaluation of investments, significant decline in deposit rates,
relative stickiness of lending rates, and a significant decline in intermediation costs.
Net operating income (excluding trading profits from investments) as percent of
average assets increased from 3.84% during FY2002 to 3.99% during FY2003.
However, net profit fr om sale/revaluation of investments, as percent of average
assets, increased from 0.25% during FY2001 to 0.66% during FY2002 to 0.88%
during FY2003. Such increase in trading profits have been primarily responsible
for the significant improvement in profitability during FY2002-03. A major thrust
of policy-makers during the last few years has been to reduce the relatively high
cost of doing business in India. A key element in this cost structure has been the
high cost of funds, i.e., interest rates. The signalling impact of the reduction in the
bank rate, the CRR, and the lowering of rates on several long-term contractual
savings scheme (PPF and GPF) has led to the lowering of the long-term interest
rates in all segments of the financial markets, a decline in deposit rates and cuts in
 PLR. The following Table depicts the profitability of SCBs during the period
FY1999-2003.
Profitability Analysis of SCBs

Source: reuters
It can be observed from the table below that in spite of high net interest margins of
PSBs, the reason for the higher RoA of OPBs and foreign banks was higher yields
(total income/total average assets) rather than lower expenditure (total
expenditure/total assets). One reason for this is that, as a proportion of total assets,
PSBs’ investments in lower yielding government securities is larger than of old
private banks, and foreign banks. The system of managerial compensation makes
the PSBs risk averse, and deploying funds in government securities lowers the risk
of NPA generation. Further, as compared with foreign banks and NPBs, PSBs
provisions for NPAs, as percent of gross NPAs, is lower as compared with foreign
banks. At end-FY2003, PSBs' loan loss reserves as percent of gross NPAs was
53.9%, as compared with 42.1% for NPBs, 40% for OPBs, and 68.2% for foreign
banks.

Bank Group-wise Profitability Analysis—FY2003

(% of average assets)

Source: rbi.org/
The yields of the foreign banks is also boosted by their non-interest income and
higher exposure to consumer finance. During FY2003, commission, exchange and
brokerage constituted 11.5% of income of foreign banks, compared with 8.1% for
the SBI & associate banks, 5.9% for private sector banks, and 4.2% for
nationalised banks. This is because of the higher off-balance liabilities of foreign
banks. Apart from excellent treasury skills, the foreign banks have also managed to
generate higher profitability ratios from the consumer finance boom in India. In
consumer finance, not only the yields are higher but also the risk of NPAs is lower.
Personal loans accounted for 23.6% of outstanding credit of foreign banks at end-
FY2002, as compared with 12.5% for PSBs. As discussed above, because of their
greater thrust on consumer financing, foreign banks have consistently enjoyed
higher yields and margins. By contrast, with the slowdown in the economy, PSBs
have only recently placed increased focus on consumer financing. Personal loans
accounted for 12.5% of their credit at end-FY2002, as compared with 9.8% at end-
FY1999. By contrast, the share of industry declined from 49.1% to 37.5%. Another
factor for the higher profitability of NPBs and foreign banks is the relatively low
proportion of rural branches and credit. As of end-FY2002, private sector banks
had 20.5% of their branches in rural areas, as compared with nil for foreign banks,
and 40.4% for PSBs. Foreign banks also have significantly lower exposure to the
priority sector than other domestic banks.
Advances to Priority Sector as percentage of net bank credit—end-FY2003

The profitability of SCBs in India is generally higher than in the developed and
East Asian countries. As the following table indicates, the return on assets of banks
in East Asia turned negative in the late-1990s because of the large losses as a result
 of the financial crisis.

Banks’ return on assets in select countries

(percent)

Capital Adequacy
The following Table presents the performance of the SCBs with respect to capital adequacy.
Capital Adequacy Ratio—FY2002-03
(Number of banks)

Overall CAR of SCBs in India has improved from 10.4% during FY1997 to 11.9%
during FY2002, and to 12.6% during FY2003. During the last two years, there has
been a significant improvement in CAR because of significant increase in
profitability and issue of equity shares on the capital markets. The CAR of PSBs
improved from 10% during FY1997 to 11.8% during FY2002, and to 12.7% during
FY2003. Indian banks have, traditionally, had access to five sources of capital: the
government, domestic equity markets, foreign markets, private placement of
subordinated bonds, and internal capital generation. Because of low levels of
profitability achieved by most banks, internal capital generation alone does not
always compensate for business growth and risk coverage needs.

Capital Injection by government

There has been a distinct improvement in the capital adequacy position of the
Indian banking sector since the initiation of reforms in the early 1990s. The PSBs
capital has increased mainly because of the infusion of capital by the government
and equity capital through the capital market. Till FY2003, the government had
injected Rs. 230 billion towards recapitalisation of 19 nationalised banks. Some
banks had to resort to repeated doses of capital infusion to achieve the capital
adequacy requirements, and to provide for loan loss provisioning.
Capital infusion amounts to writing off the capital invested earlier. In theoretical
terms, it satisfies the condition that existing equity owners (the government, in this
case) must first bear the loss when a bank goes bankrupt. It also means an
immediate access to fresh equity to tide over solvency issues. Though new equity
is one of the first-defense instruments in bank restructuring, its efficacy depends on
the incentives it seeks to promote. If the new equity is pegged to strong incentives
to banks to change their working procedures, the effect will be markedly different
from the case where it is a no-questions-asked attempt to shore up the balance
sheet. In the Indian case, capital infusion was tied to ambiguous and asymmetric
incentives. For example, the Memorandum of Understanding approach (where the
regulatory authority and the bank management would agree to a charter on
minimum performance benchmarks for the coming year) initiated in 1993-94, was
pegged to added benefits if the bank met the criteria, not to negative caveats if it
failed. Not unsurprisingly, the rate of slippage was high. By 1996, the RBI was
forced to threaten penalties if banks failed to deliver on the agreed benchmarks, but
no action was subsequently taken perhaps because of the difficulty in isolating
management failure from the economic factors impacting bank performance.

Tapping the Capital Market

The ownership of the GoI in the PSBs has been gradually diluted with several
PSBs making public offerings of their equity shares. PSBs were first able to raise
capital in the domestic equity markets in the early 1990s and, SBI was the first
PSB to raise resources through an initial public offering (IPO) in December 1993.
During 1993-2002, as many as 12 PSBs raised Rs. 65.01 billion through public
issues. The trend of PSBs raising resources through the capital markets accelerated
in 2002-03. During 2002-03, four more PSBs including the Punjab National Bank,
Allahabad Bank, Union Bank of India, and Canara Bank came out with their equity
issues. With this, the total amount raised by PSBs through equity issues till end-
FY2003 aggregated Rs. 72.74 billion. During FY2004, the PSBs which raised
resources through public issues include Indian Overseas Bank (Rs. 2.4 billion),
UCO Bank (Rs. 2.4 billion), Vijaya Bank (Rs. 2.4 billion), and Bank of
Maharashtra (Rs. 2.3 billion). The trend of banks accessing the capital markets is
expected to accelerate as government funding for recapitalisation decreases over
the coming years.

Capital Write-offs
It is important to note that the government has allowed banks to write off capital
against their losses to help them shore up their capital. Such assistance has
generally been extended to weaker 15 banks, which face difficulty in complying
with progressively stricter capital adequacy norms, or banks, which face one-off
crises. An example of the latter is Canara Bank, which received Rs. 6 billion in
FY1998 after its mutual fund subsidiary suffered a large loss. In recent years, while
Central Bank of India wrote off losses from its paid-up capital amounting to
Rs.6.81 billion during FY2002, UCO Bank wrote-off losses of Rs. 16.65 billion
during FY2003. The increase in CAR from 8% to 9% has strengthened the
financial soundness of banks while continuing to keep them in line with the
international standards. Foreign banks are generally better capitalised than
domestic banks. This is reflected in the fact that their networth, as percent of
liabilities, aggregated 11.5% at end-FY2003, as compared with 6.4% for private
sector banks, and 5.1% for PSBs. As the following table indicates, the overall
CRAR of the SCBs in India, although rising over the last five years, and much
above the prescribed level, is lower than that of US, and several countries in Asia
& Latin America.
Banks’ CAR in select countries

Asset Quality
An important parameter in the analysis of the financial performance of banks is the
level of NPAs. The information on NPAs helps banking supervisors to monitor and
discipline errant banks and allows investors estimate the true financial worth of
banks. The NPA levels of Indian commercial banks at the gross and net levels
continue to be high. However, NPA levels declined during FY2003, because of
improved risk management practices, greater recovery efforts, driven somewhat by
the Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interest (SARFAESI) Act, 2002 enacted in December 2002. The
SARFAESI Act enabled SCBs to recover around Rs. 7.69 billion till end-
September 2003. Overall recoveries of PSBs improved from Rs. 140.59 billion
during FY2002 to Rs. 187.30 billion during FY2003. Gross NPAs of all SCBs
declined 3% during FY2003 to Rs. 687.75 billion at end-FY2003, as compared
with a growth of 11.3% during FY200216. Banks have been making pro-active
efforts towards increasing their provisioning levels. As a result, net NPAs declined
7.9% during FY2003 to Rs. 328.12 billion, as compared with a growth of 9.7%
during FY2002. While incremental gross NPAs declined from Rs. 71.95 billion in
FY2002 to Rs. 20.99 billion in FY2003, incremental net NPAs declined from Rs.
31.59 billion to Rs. 28 billion.
Bank Group-wise Gross and Net NPAs

322 356.12
Source: onlinesbi.co.in

While the gross NPAs, as a percentage of gross advances of SCBs, declined from
10.4% at end-FY2002 (14.7% at end-FY1999) to 8.8% at end-FY2003, the net
NPA, as a percentage of net advances, also declined from 5.5% to 4.3% (7.6% at
end-FY1999).
Bank Group-wise Gross and Net NPAs

Source: banknetindia.com/
Gross NPA, as per cent of assets, declined from 4.6% at end-FY2002 (6.2% at end-
FY1999) to 4.1% at end-FY2003. Similarly, net NPAs, as percent of assets, also
declined from 2.3% at end-FY2002 (3% at end-FY1999) to 1.9% at end-FY2003.
Although stricter provisioning norms have resulted in a decline in net NPAs, as
percent of net advances, over the years, they remain high as compared with
developed country standards of around 2%.

Bank non-performing loans to total loans

 While PSBs and foreign banks have witnessed a decline in net NPAs, NPBs have
reported increased NPAs because of significant expansion in business, and also
because of the impact of merger of ICICI and ICICI Bank. Overall Net NPAs, as a
percent of net worth, also remain high at 33.5% at end-FY2003, although it has
declined from 51% at end-FY1999.

Bank Group-wise Gross and Net NPAs as percent of assets

.9232.5%
Source: goidirectory.nic.in/

The high level of NPA in the banking sector is attributable to past directed-lending
practices. For PSBs, gross NPAs under priority sector aggregated Rs. 249.38
billion at end-FY2003, and accounted for 47% of their gross NPAs. In 10 out of 27
PSBs, priority sector NPAs constitute more than 50% of gross NPAs. Recovery of
NPAs under priority sector advances particularly to agriculture and small-scale
industries (SSI) is often hampered by the fact that such NPAs are also spread over
a large number of accounts and for small amounts. Although there has been a
decline in the number of sick-SSI and non -SSI (sick/weak) industrial units
financed by SCBs in recent years, outstandings locked up in sick/weak industries
increased marginally from Rs. 257.78 billion at end-FY2001 to Rs. 260.65 billion
at end-FY2002. Bank loans outstanding to SSI Sector as a percentage to NBC has
declined from 17.5% at end- FY1998 to 11.1% at end-FY2003. SCBs have also
been unable to take effective action against many large corporate borrowers in
default. It is also a fact that the archaic legal systems and procedures lead to a time
lag in settlement of cases as also in the eventual disposal of assets causing a
persistent rise in NPAs. In a causative study conducted by the RBI, the major
factors that led to NPAs in the Indian context include: (a) diversion of funds; (b)
product/marketing failure, inefficient management, inappropriate technology,
abour unrest, etc.; (c) changes in the macro-environment; (d) inadequate control
and supervision; e) changes in government policies; (f) delays in release of
sanctioned limits by banks; and (g) wilful default.
The category-wise classification of NPA figures shows that PSBs and OPBs have
the highest NPAs while foreign banks have the lowest. The appraisal methods of
the private sector banks, especially the older private sector banks, may not be as
sophisticated, methodical and elaborate as in the case of some of the PSBs.
However, private sector banks' monitoring and follow-ups are more personalised.
In the case of foreign banks, not only are they selective in granting credit, but they
also have a precise and focused appraisal system and deliver credit faster. The
collateral taken by them would not be as much as in the case of PSBs but follow-
ups and monitoring are better and personalised. In other words, without external
surveillance and a more elaborate or lengthy appraisal system, new private and
foreign banks are getting better results. The exposure taken by the private and
foreign banks are largely lower than that of the PSBs. The PSBs have a larger
number of bigger accounts with comparatively high exposure to individual
companies. A lot of the asset quality deterioration has taken place in the smaller
accounts. Indian banks' loan customers are typically (loss-making) manufacturers
and small businesses in rural and semi-urban areas. Reduction in import duties,
abolition of the licensing system and decline in realisations in certain key
commodities have brought considerable stress to many big banking clients. The
antiquated legal system in India, and the time consuming and long drawn legal
process adds to the burden and contributes to fresh accretion of NPAs. Court
judgements against defaulters can take 10 years or more and even then may not be
enforced. The delays and favourable treatment for sick companies, have led to even
some non-sick firms to take advantage of `sick status’. Banks thus face
considerable difficulties in the recovery of dues and enforcement of securities.
Recognising the weaknesses in the legal framework, the GoI passed the Recovery
of Debts due to Banks and Financial Institutions Act, 1993. The Act provided for
the creation of Special Tribunals for banks and financial institutions. Monetary
claims worth Rs. 1 million and above can be adjudicated by the Debt Recovery
Tribunals (DRTs). Some of the provisions of this Act were amended in January
2000 and certain new provisions have been incorporated for strengthening DRTs
(power to attach defendant's property/assets before judgement, power to appoint
receiver of any property of the defendant before or after grant of recovery
certificate, etc.). However the DRTs have not been very effective so far. As of June
2003, only 22,163 cases had been adjudicated by the DRTs and an amount of Rs.
57.87 billion was recovered.

The Securitisation and Reconstruction of Financial Assets and Enforcement of

Security Interest Act, 2002 (SARFAESI)
The Narasimham Committee had recommended the setting up of asset
reconstruction companies (ARCs), which would be legally separate entities to
which banks can sell their NPAs. The NPAs would then be recovered by the ARCs
through attachment, foreclosure or liquidation. The Union Budget 2002-03 had
proposed setting up a pilot ARC to conduct auctions of NPAs, and to develop a
market for securitised loans. Subsequently, The Securitisation and Reconstruction
of Financial Assets and Enforcement of Security Interest Ordinance, 2002 was
promulgated in June 2002 to regulate securitisation and reconstruction of financial
assets and enforcement of security interest. In December 2002, the Indian
Parliament passed `The Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002’ (SARFAESI) which enables the
setting up of asset management companies to address the problems of NPAs of
banks and FIs. SARFAESI provides for enforcement of security interest for
realisation of dues without the intervention of courts or tribunals. The salient
features of the Act are:
1. A securitisation or reconstruction company (SRC), with owned fund of not less
than Rs. 20 million or not exceeding 15% of total financial assets acquired or to be
acquired as specified by the RBI, can commence or carry on business after
obtaining a certificate of registration (CoR).
2. The SRC can raise funds from qualified institutional borrowers by formulating
schemes for acquiring financial assets.
3. If, on the date of acquisition of financial asset, any suit, appeal or other proc
eeding of whatever nature relating to the said financial asset is pending by or
against the bank or FI, save as provided in the third proviso to sub-section (1) of
section 15 of the Sick Industrial Companies (Special Provisions) Act, 1985 (1 of
1986) the same shall not abate, or be discontinued or be, in any way, prejudicially
affected by reason of the acquisition of financial asset by SRC as the case may be,
but the suit, appeal or other proceeding may be continued, prosecuted and enforced
by or against the SRC, as the case may be.
4. The SRC company can acquire assets of any bank/FI through the issuance of
debentures/bonds or agreements with banks/FIs. The notice of acquisition may be
sent by banks/FIs to the concerned obligor, who, on receipt of such notice, will
make the payment to the concerned SRC.
5. In the event of non-realisation, qualified institutional buyers of the SRC holding
not less than 75% of the securities issued by the SRC are entitled to call a meeting
of all institutional buyers and the resolution passed in such a meeting is binding on
the company.
6. A SRC may provide for the proper management of the business of the borrower,
sale or lease of a part or whole of the business of the borrower, settlement of dues
payable by the borrower and taking possession of secured assets within the
framework of RBI guidelines.
7. Secured creditor is entitled to enforce any security interest created in its favour
without the intervention of a court or a tribunal. In the case of non -performing
debt, the secured creditor is entitled to serve a notice to the borrower to discharge
its liabilities within 60 days of the date of notice.
8. In case of failure of the borrower to discharge its liabilities, the secured creditor
may take recourse to one or more of the following measures to recover his secured
debt, namely (a) take possession of the secured assets of the borrower including the
right to transfer by way of lease, assignment or sale for realising the secured asset;
(b) take over the management of the secured assets of the borrower including the
right to transfer by way of lease, assignment or sale and realise the secured asset;
(c) appoint any person to manage the secured assets the possession of which has
been taken over; (d) require at any time by notice in writing, any person who has
acquired any of the secured assets from the borrower and from whom any money is
due or may become due to the borrower, to pay the secured creditor, so much of
the money as is sufficient to pay the secured debt.
9. Where the possession of any secured assets is required to be taken by the
secured creditor or if any of the secured assets is required to be sold or transferred
by the secured creditor under the provisions of the Act, the secured creditor may
request the assistance of the concerned Chief Metropolitan Magistrate or the
District Magistrate.
10. Borrower may appeal to the Debts Recovery Tribunal (DRT) having
jurisdiction in the matter within 45 days from the date on the secured creditor had
taken action under (8) above. The borrowers must also deposit with the DRT, 75%
of the amount claimed by the secured creditor, failing which the appeal shall not be
entertained by the DRT. Borrowers aggrieved with the order of the DRT may
appeal to the Appellate Tribunal within 30 days of the date of receipt of order from
the DRT.
ARCs have been used extensively in many countries that have experienced
banking problems in the past two decades. However, the performance of the ARCs
have been mixed in many countries. To be effective, the ARC should be run on
commercial problems. Ownership of ARCs by SCBs and FIs also raise conflicts of
interest in the sense that as sellers of NPS, banks and FIs have an incentive to ask
for a high price for the assets sold, thereby impacting the profitability of the ARC.
An effective strategy must also include the financial and operational restructuring
 of unviable industrial borrowers.

Apart from SARFAESI, the GoI has also notified the Security Interest
(Enforcement) Rules, 2002 to enable secured creditors to authorise their officials to
enforce the securities and recover the dues from the borrowers. PSBs and FIs have
been advised to take action under SARFAESI and report compliance to the RBI.
Since SARFAESI provides for sale of financial assets by banks/FIs to SRCs,
guidelines have been issued by the RBI to ensure that the process of asset
reconstruction proceeds on sound lines. These guidelines, inter-alia, prescribe the
financial assets which can be sold to SRCs by banks/FIs, procedure for such sales
(including valuation and pricing aspects), prudential norms for the sale transactions
(provisioning/valuation norms, capital adequacy norms and exposure norms) and
related disclosures required to be made in the Notes on Accounts to balance sheets.
SARFAESI, 2002 has the potential to serve as an important tool for banks and FIs
in the recovery of the dues. PSBs had identified (as per latest estimates) NPAs
worth over Rs. 120 billion to be sold to the ARCs; however, the process of
valuation of the loans prior to sale is yet to be completed.

COMPETITION FROM OTHER INSTITUTIONAL

INTERMEDIARIES
Financial Institutions
The FIs in India can be classified as all-India financial institutions (AIFIs), state
level institutions, and other institutions. Within these categories, FIs can be
classified according to main functions: (a) all India development banks (AIDBs)
comprising IFCI Ltd., Industrial Development Bank of India (IDBI), Small
Industries Development Bank of India (SIDBI), and Industrial Investment Bank of
India Ltd. (IIBI); (b) specialised financial institutions comprising Export Import
Bank of India (EXIM), IFCI Venture Capital Funds (IVCF, formerly RCTC) Ltd.,
ICICI Venture Ltd. (formerly TDICI), Tourism Finance Corporation of India
(TFCI) Ltd., and Infrastructure Development Finance Company (IDFC) Ltd.; (c)
investment institutions such as Life Insurance Corporation (LIC), Unit Trust of
India (UTI) and General Insurance Corporation (GIC) and four erstwhile
subsidiaries; and (d) refinance institutions such as National Housing Bank (NHB)
and National Bank for Agriculture and Rural Development (NABARD). The State-
level institutions include State Financial Corporations (SFCs) and State Industrial
Development Corporations (SIDCs). Besides the AIFIs and State-level FIs, in the
agricultural and rural sector and the housing sector, the National Bank of
Agriculture & Rural Development or NABARD and the National Housing Bank or
NHB, respectively, are acting as the chief refinancing institutions.
The overall importance of FIs is attested by the fact that their financial assets
aggregated Rs. 5,673 billion at end-FY2003. The prominent AIDBs or
development FIs (DFIs) such as ICICI (pre-merger), IDBI, IFCI, SIDBI, IIBI, and
IDFC are largely engaged in providing medium- and long-term loans
predominantly in the form of project finance. In the pre-reform era, the DFIs
played a pioneering role in catalysing broad-based industrial development in the
country in keeping with their Government-ordained development banking charter.
DFIs had access to low cost funds like concessional National Industrial Credit
(Long-term Operations) or NIC (LTO) funds19, government guaranteed funds from
bilateral/multilateral agencies and issues of SLR bonds. This enabled the DFIs to
provide long-term financing to industry at concessional rates. Through RBI
regulations, the DFIs were also largely protected from competition by SCBs, by
keeping SCBs away from extending large-sized term loans to industrial units.
Banks were expected to provide small term loans to small-scale industrial units on
a priority basis.
However, following the reforms in the financial sector since the 1990s, DFIs
sources of lowcost funds were gradually phased out, resulting in an increase in the
cost of funds for DFIs. The business of the DFIs was also adversely impacted by
the softening of the interest rates from the second half of the 1990s, and the
deceleration in the industrial sector from FY1997. The industrial slowdown not
only adversely impacted the sanctions and disbursements of DFIs, but also resulted
in a deterioration of their asset quality. In a declining interest rate environment,
DFIs with their traditional reliance on long-term sources of funds, became
increasingly uncompetitive.
DFIs are now facing increased challenges both on the asset and liability sides. The
functional barriers amongst different types of financial intermediaries are getting
blurred with increasing competition and deregulation. On the liabilities side, with
the drying up of concessional sources of funds from the GoI, DFIs are raising
resources including short-term funds at market-related rates. On the asset side, the
distinction between SCBs and DFIs are getting blurred as both are now offering
long- and short-term financing. With their extensive branch network, the SCBs
have access to low-cost retail deposits. The SCBs have increasingly competed with
DFIs in providing long-term financing, with the share of term loans by SCBs in
their loan portfolio increasing from 30.2% at end-FY1997 to 44.5% at end-
FY2003. However, given the comparative advantage of the DFIs in project
appraisal and other techniques associated with term financing, and of SCBs in
assessing WC requirements, it would take some time for each of them to specialize
in the skills of the other.
Select Indicators of DFIs and SCBs

During the 1990s, the avenues for raising long-term finance for the Indian
corporates has also undergone a significant shift. While the share of equity capital
in the financing of projects increased significantly, the share of loans and bonds/
deben tures in financing of projects decreased during the same period. With
corporates now having increased access to the banking system and international
capital markets for their long-term financing needs, the channelisation of funds
from the traditional source of long-term finance to the corporate sector, i.e., DFIs
has been slowing down. Component-wise, of the total loan financing of projects,
the share of DFIs declined during the 1990s, while the share of banks rose from
levels of the 1980s, thereby overtaking the position of FIs in project finance.
 ICICI,

Since the late-1990s, the performance of DFIs has been on a downward trend. In
contrast to the rising trend in financial assistance sanctioned and disbursed by the
DFIs till FY2001, the sanctions and disbursements of DFIs have declined during the
last few years. The net flow of resources from DFIs has been negative for the past
two years—Rs. (-47.06) billion during FY2002, and Rs. (-53.21 billion) during
FY2003. Slowdown in various sectors of the economy, lack of demand for new
projects, existence of market-based sources of project finance for Indian corporates,
competition from lower interest rates provided by SCBs, and delays in
implementation of projects, have all contributed to the substantial decline in the
financial assistance sanctioned and disbursed by DFIs. Furthermore, the recent spurt
in the growth of services sector may not have generated commensurate demand for
project finance as a number of service industries are human capital-intensive with
somewhat limited requirement of long-term finance.
Sanctions and Disbursements of AIFIs
(Rs. million)

The DFIs which have the principal objective of providing term-finance for fixed
asset formation in industry face a high risk profile due to the inherent long-term
nature of their lending. Recent statistics indicate that NPAs of DFIs, both in
percentage and in absolute terms, have gone up during the post-reform period. This
highlights the fact that while new NPAs are being added to DFIs operations every
year, there are time lags in the recovery of older dues. Unlike SCBs, DFIs are
burdened with higher levels of NPAs, on account of their skewed exposure in the
traditional commodity sectors, whose performance slowed down considerably in
the recent post-reform years. While the net NPAs of FIs comprising IDBI, IFCI,
IIBI, EXIM, TFCI, and IDFC increased from Rs. 113.72 billion at end-FY2002 to
Rs.142.97 billion at end-FY2003, the ratio of net NPAs to net loans increased from
15% to 18.8%. The balance sheets of leading DFIs such as IDBI and IFCI have
been affected substantively by NPAs resulting in erosion of their net worth.
In response to the increased competition from SCBs, the RBI has indicated that it
would consider proposals from long-term lending institutions desirous of
transforming themselves into banks on a case-by-case basis. In April 2001, the RBI
issued guidelines on several operational and regulatory issues, which were required
to be addressed in evolving the path for transition of a long-term lending institution
into a universal bank. Accordingly, some Fis have taken initiatives in this direction.
In the earliest instance, ICICI Ltd. approached the RBI with its proposal for
conversion to a bank by means of reverse merger with its subsidiary ICICI Bank
Ltd. The RBI gave clearance in April 2002, subject to certain terms and conditions
relating to, inter alia, reserve requirements, prudential norms, etc.
Similarly, in order to pave the way for conversion of IDBI into a universal bank,
the Parliament enacted the Industrial Development Bank (Transfer of Undertaking
and Repeal) Act, 2003 to provide for the transfer and vesting of the undertaking of
the IDBI to, and in, the Company to be formed and registered as a Company under
the Companies Act, 1956 to carry on banking business, and also to repeal the
Industrial Development Bank of India Act, 1964. The Act envisages transfer of all
the assets and liabilities of the extant IDBI into a company (under the Companies
Act) bearing the appellation `Industrial Development Bank of India Ltd.' (IDBI
Ltd.) to transact banking business. All the existing shareholders of IDBI would
automatically become shareholders of the banking company. The new entity will
not require a separate banking licence to be issued by the RBI under the Banking
Regulation Act, 1949 because it is deemed to be a banking company in terms of the
provisions of the Act. However, branches of IDBI Ltd. would require a licence
from RBI to commence operations. Further, the only regulatory forbearance
provided in the Act is in respect of maintenance of Statutory Liquidity Ratio (SLR)
 at the prescribed levels for a period of five years from the `appointed date'. The
crucial coven ant in the Act is the mandatory continuance of its development
finance role or term lending to industry, alongwith the entire gamut of banking
activities.
The GoI and the major shareholders of IFCI have also been engaged in devising
ways and means to restore IFCI's viability on a sustainable basis. In the interim, the
GoI put into effect a restructuring package designed to arrest further deterioration
of its financial health. As a step towards conversion into a universal bank, the
Board of Directors (BoDs) of IFCI decided on January 30, 2004 to merge IFCI
with Punjab National Bank (PNB), subject to requisite approvals and to initiate
further necessary steps in this regard. On the same date, the BoDs of PNB also
accorded in-principle approval for the taking over of IFCI by PNB. Conversion of
DFIs into SCBs has many positive aspects. At present, statutory constraints on
raising cheap retail deposits (maturity should not be less than 1 year) have meant
that DFIs have been unable to protect interest margins, putting pressure on
profitability. With conversion into a bank, DFIs would have access to short-term
retail deposits, which would significantly reduce their funding costs. The cost of
funds for SCBs in India have been lower than those for DFIs, primarily because of
shorter maturity structure of SCBs liabilities.

Maturity Profile of Select Liabilities/Assets at end-FY2003

Source: rbi.org/

As a result of their cost of funds, SCBs are also able to lend at relatively lower rates
as compared to the DFIs. A universal bank would also be ex pected to provide the
full range of banking products to its customers, from small loans for retail
individuals to project financing for big corporates and multinationals. Significant
opportunities for cross-selling various products also arise, including bank accounts,
credit cards, depositary share accounts and, retail loans. In case of a merger with an
established bank, the combined customer base of the two entities could provide the
appropriate critical mass that would facilitate retail initiatives. With a big capital
base, the new merged bank entity would be able to further exploit its corporate
relationships to develop fee income. The merged entity could leverage on its large
capital base, comprehensive range of products and services, extensive corporate and
retail customer relationships, brand franchise, and talent pool. Cost-cutting benefits
could be derived from merging overlapping back-office operations and departments
of the two entities. DFIs would also be better positioned to manage and diversify
their loan book, as well as derisk their balance sheet away from project financing.
This is likely to lead to an improved credit risk profile. In an effort to diversify its
loan book, IDBI has already been following a very cautious approach towards
project finance, by minimising any new advances to this relatively high-risk sector.
Instead, IDBI is gradually evolving into a commercial bank, and has endeavoured to
increase its non -project based financing to well-performing corporates, catering to
their needs for WC finance and short term loans. Such loans tend to be more
profitable and carry less credit risks.
However, mergers with an established bank/conversion into a universal bank has
some negative features. In case of a merger, the asset quality of the merged entity
could deteriorate. For example, based on the annual accounts for FY2003, while the
merged IFCI-PNB bank entity would have an asset base of Rs. 1,079 billion, making
it the second-largest SCB in India, it would have gross NPAs of Rs. 136 billion.
Thus, it would have gross NPAs of 12.6% of assets, which is significantly higher
than the combined average of 4% of all SCBs in India at end-FY2003. Higher NPAs
would severely impact income, and reduce the competitive advantage of the merged
entity. The merged entity/DFI converted into a bank could also have to meet priority
sector requirements. Priority sector advances have a higher default rate, and could
have a negative impact on asset quality. However, lending to the housing sector,
small- and medium-sized enterprises (SMEs) and the agricultural sector, which all
falling under the priority sector, should enable the universal bank to meet the RBI
requirements without significant deterioration in asset quality. Conversion into a
universal bank may also result in compliance with CRR and SLR requirements.
 Non-Banking Finance Companies
In terms of the Section 45I(f) (read with Section 45I(c)) of the RBI Act, 1934, the
principal business of non -banking finance companies (NBFCs) is that of receiving
deposits, or that of a financial institution (FI), such as, lending, investment in
securities, hire purchase (HP) finance or equipment leasing (EL). NBFCs are of
various types, such as loan companies (LCs), investment companies (ICs), hire
purchase finance companies (HPCs), equipment leasing companies (ELCs), mutual
benefit financial companies—also known as Nidhis—miscellaneous non-banking
companies—also known as Chit Funds—and residuary nonbanking companies
(RNBCs).
Business Profile of NBFCs

Source: banknetindia.com/

Although significantly smaller than SCBs, NBFCs are regarded as one of the major
institutional purveyors of credit in India. Traditionally, both banks and NBFCs
have predominantly extended short-term credit. NBFCs have displayed flexibility
in meeting the credit needs of specific sectors like EL, HP, housing finance and
consumer finance, where gaps between the demand and supply of funds have been
high and where SCBs were earlier not easily accessible to borrowers. NBFCs in
India offer a wide variety of financial services and play an important role in
providing credit to the unorganised sector and to small borrowers at the local level.
As compared with many SCBs, they have an ability to take quicker decisions,
assume greater risks, and customise their services and charges more according to
the needs of the clients. This enables them to build up a clientele that ranges from
small borrowers to established corporates. By employing innovative marketing
strategies and devising tailor -made products, NBFCs have also been able to build
up a clientele base among the depositors, mop up public savings and command
large resources. Consequently, the share of non -bank deposits in household sector
savings in financial assets, increased from 3.1% in FY1981 to 10.6% in FY1996. In
1998, the definition of PDs was for the first time contemplated as distinct from
regulated deposits and as such, the figures thereafter are not comparable with those
before. Nevertheless, at end-March 2002, non-bank deposits accounted for 2.9% of
the financial assets of the household sector in India.
Although NBFCs in India have existed for a long time, they shot into prominence
from the late-1980s. This rapid expansion was driven by the scope created by the
process of financial liberalisation in fresh avenues of operations in areas, such as,
HP, EL, housing, and investment. The rapid growth of the NBFCs sector can also
be attributed to other factors. NBFCs were historically subjected to a relatively
lower degree of regulation vis-à-vis banks. Secondly, the higher rates of return on
deposits offered by NBFCs enabled them to attract a large base of small savers.
Added to these was the fact that the operations of NBFCs were characterised by
several distinctive features viz., no entry barriers, limited fixed assets and no
holding of inventories-all of which led to a proliferation of NBFCs. During 1991-
98, the total assets of NBFCs increased at a CAGR of 36.7%. The deposits of
NBFCs as a proportion of bank deposits increased sharply from 0.8% during
FY1986-90 to 9.5% in FY1997. However, since 1997, a combination of economic
slowdown, loss of investor confidence, and tightening of regulations, has resulted
in the weeding out of many NBFCs with insufficient capital base. Till 1997,
although NBFCs were regulated by the RBI, the focus was mainly on the liability
side. In 1997, the RBI was conferred with extensive powers for regulation and
supervision of NBFCs (discussed below). Because of regulation and weeding out
of many NBFCs, the total PDs of NBFCs have declined from Rs. 238.20 billion at
end-FY1998 to Rs. 188.22 billion at end-FY2002.

In terms of distribution of assets, there has been a significant shift in asset

deployment away from the traditional business of EL/HP towards loans, ICDs and
investments. While the share of EL/HP in total assets declined from 42.9% at end-
March 2000 to 41% at end-March 2002, the share of loans, ICDs, and investments
increased from 70.4% to 78.4%.

With SCBs now offering the same spectrum of services as NBFCs, the distinction
between SCBs and NBFCs is narrowing. On the liabilities side, after an increase in
business till the mid-1990s, NBFCs now face increased competition from SCBs.
Banks and PD-accepting NBFCs compete for deposits. Besides, banks and NBFCs
are also competing sources of funds in certain sections of the credit markets. Even
though SCBs offer much lower interest rates on deposits, their deposits have
increased at a much faster rate in recent years, as compared with NBFCs.
Indicators of Competition between SCBs and NBFCs

Because NBFCs cannot accept PDs of less than 1-year maturity, bank deposits
score higher than NBFCs on the liquidity account, and continue to retain their
dominance in the portfolio of household financial savings. Nearly 38% of
outstanding deposits of SCBs at end-March 2003 were for a maturity of less than 1
year, as compared with 34% at end-March 2002. By comparison, only 25% of the
outstanding PDs of the NBFCs (excl. RNBCs) at end-March 2002 were for
maturity of less than 1-year. The interest rate offered by NBFCs is much higher
than by SCBs. Overall the cost of funds is higher for NBFCs than for SCBs. While
the NBFCs reported financial expenditure of 8.3% of total assets, SCBs reported a
decline in interest expenditure, as percent of assets—from 5.7% during FY2002 to
5.5% during FY2003.

After the securities scam of 1992, bank deposit mobilisation increased, as a greater
part of the household sector savings started to move from the stock markets to the
banking sector. By contrast, the disturbing developments in the NBFC sector
during the mid-1990s, tightening of supervision, and closures have resulted in
NBFCs commanding a lower share of both deposits and financial assets of the
household sector. Public/regulated NBFC deposits, as a percent of GDP declined
from 1.2% during FY1999 to 0.7% during FY2003. Over the same period, bank
deposits outstanding, as percent of GDP, increased from 40.5% to 50.1%. The
pattern of household financial savings also indicates a continued preference of
households for relatively safer instruments (bank deposits, insurance, provident and
pension funds, and small savings).

Notwithstanding the increased competition between banks and NBFCs, and the
dominance of SCBs, there are areas of operational convergence due to their
engagement in similar types of activities in the broad product space of deposit
mobilisation and lending. A critical issue for regulation and supervision is the
desirable degree of regulatory convergence between banks and NBFCs. It is in this
context that the RBI's regulatory framework for NBFCs, largely follows the
regulations for banks but also differs in a number of cases.

Mutual Funds
The mutual fund (MF) industry in India began with the setting up of the Unit Trust
In India (UTI) in 1964 by the GoI. In 1987, PSBs and insurance companies were
permitted to set up MFs. In 1993, Securities Exchange Board of India (SEBI)
formulated the Mutual Fund (Regulation), 1993, which for the first time
established a comprehensive regulatory framework for the MF industry. This also
led to the private and foreign players in the MF industry.

The MF industry in India has passed through three phases. The first phase was
between 1964 and 1987, when UTI was the only player. UTI had assets
aggregating Rs. 67 billion at end-1988. In the second phase, between 1987 and
1993, eight funds were established by PSBs, LIC and GIC, and the total assets
under management increased to Rs. 610.28 billion at end-1994. In the third phase
from 1993 onwards, several private sector players launched their MF schemes, and
the total assets under management (AUM) increased to Rs. 1,005.94 billion at end-
FY2002, or 6.5% of the assets of SCBs. According to the Association of Mutual
 Funds in India (AMFI), the total AUM had increased to Rs. 1,396.16 billion at end-
March 2004.

Net Resource Mobilisation and AUM of the MF industry in India

(Rs. billion)

Source: onlinesbi.co.in

After a lacklustre performance from FY1996 to FY1999, the MFs industry reported
a substantial improvement in performance during FY2000. While MFs on a net
basis increased their resources from Rs. 26.95 billion in FY1999 to Rs.199.53
billion in FY2000, there was a decline in accretion to bank deposits from
Rs.1,155.40 billion in FY1999 to Rs. 993.20 billion in FY2000. Thus, there was a
shift of savings from bank deposits to MFs.

However, after a significant improvement during FY2000, the MF industry

suffered a setback during FY2001-03, with a significant decline in net resource
mobilisation. By contrast, accretion to bank deposits increased 50.3% during
FY2001, declined 5.7% during FY2002, and increased 26.1% during FY2003. The
MF industry suffered a decline in net resource mobilisation since FY2001 mainly
because of the subdued state of capital markets. The BSE Sensex, which had
increased from a monthly average of 3,689 in March 1999 to 5,650 in February
2000, declined to 5,262 in March 2000. The BSE Sensex on an average declined
8.3% during FY2001, 22% during FY2002, and 3.8% during FY2003 (to 3,156 at
end-FY2003). However, resource mobilisation by MFs has witnessed a sharp
increase since mid-2003 because of the recovery in the capital markets, with the
average BSE Sensex increasing from 3,033 during May 2003 to 5,613 during
March 2004. The BSE Sensex on an average increased 40.1% during FY2004.
While UTI has registered net inflows during FY2004 as compared to outflows
during FY2003, the private sector MFs also recorded huge mobilisations. The
aggregate AUM increased from Rs. 795 billion at end-FY2003 to Rs. 1,396 billion
at end-FY2004.

FINANCIAL DISINTERMEDIATION
Banks have traditionally been the dominant entities of financial intermediation in
India. Financial disintermediation refers to a movement from an institution -based
system to a market-based system of mobilisation and allocation of resources. The
process is associated not only with a departure from bank-based intermediation to
non -bank based intermediation but also with a tendency of corporates to raise
resources directly through deposits, CP, etc., and through the organised domestic
and international market for equity and debentures.

The financial sector reforms undertaken in India since the early 1990s have
ushered in deregulation of the financial system, development of the capital
markets, promotion of the growth of NBFCs, and encouragement of private sector
participation. Large companies have been able to access securitised debt
domestically and from financial markets abroad. There has not only been a gradual
decline in the term deposit rates of banks, but also a general decline in interest rates
across the financial markets, including the cut in interest rates of Government
administered small saving schemes. While there has been a greater degree of
convergence of the pre-tax rates of return in the recent past, the post-tax returns on
different financial saving instruments remained mis-aligned, with bank deposits
probably being the worst off on this count. However, bank deposits score on the
liquidity account and retain their dominance in the portfolio of household financial
savings. The FIs have been increasingly provided freedom to manage their assets
and liabilities and determine the quantum of resources they need to mobilise and
deploy and set interest rates on sources and uses of funds. Certain categories of
NBFCs were given freedom in the early phase of the post reforms period to
determine their own interest rates but the free interest rates on public deposits of
NBFCs have been regulated once again.
The financial disintermediation process in India presents a mixed picture as
detailed below:
• A comparative analysis by RBI of financing patterns of select non-financial
public limited companies indicates an increasing recourse to internal
sources of financing as against the borrowed sources of funds, particularly
since the late 1990s.
• Amongst external sources of financing, the primary capital market, which
comprises the public issues and the private placement market, is a source of
funds (both equity and debt) for the corporates and an avenue for
investment of surplus funds by the investors. The new capital issues by
non-government public limited companies increased from Rs. 61.93 billion
in FY1992 to a high of Rs. 264.17 billion in FY1995. However, since then,
resource mobilisation from the public issue market has been declining. The
new capital issues by non -government public limited companies declined
to Rs. 51.53 billion during FY2000, Rs. 48.90 billion during FY2001, Rs.
56.92 billion during FY2002, Rs. 18.78 billion during FY2003, and Rs.
20.72 billion during April 2003-February 2004. During FY2004, the
primary market has remained sluggish despite a pick-up in the industrial
activity, a strong economic outlook, and a rising stock market. In contrast to
the public issues market, the private placement market has emerged as an
alternative source of funds for the corporate sector. Resources raised
through private placement by public/private financial/non -financial
institutions increased from Rs. 133.61 billion in FY1996 to Rs. 678.36
billion in FY2001, before registering a decline to Rs. 648.76 billion in
FY2002, and to Rs. 617.46 billion in FY2003.
• Resource mobilisation by Indian companies through issues of Global
Depository Receipts (GDRs)/American Depository Receipts (ADRs)
increased from US$240 million in FY1993 to a high of US$2,082 million in
FY1995 before declining to US$768 million in FY2000, US$831 million in
FY2001, US$477 million in FY2002, US$600 million during FY2003, and
US$459 million during April 2003-February 2004.
• A recent IMF study indicates that Indian companies continue to rely heavily
on external sources of finance, averaging 67% during 1990–2002. While
the amount of new equity finance raised has been large in recent years,
Indian companies are still dependent on debt finance, including bank
borrowings. In addition, new financial instruments such as CP, CDs, and
ICDs have gained popularity as a source of financing. Of the various types
of debt financing, borrowings from bans declined during the late-1990s
because of increased raising of resources from CP. However, the share of
bank borrowings has again registered an increase during the last few years
—from 32.5% during 1999 to 36.8% during 2002.
• CP represents an attractive option to eligible corporates to raise funds at an
effective rate lower than the lending rate of banks. The outstanding amount
of CP increased from Rs. 6.03 billion at end-FY1995 to Rs. 58.46 billion at
end-FY2001. CP issuance increased during FY2002, and reached a high of
Rs. 89.13 billion in mid-November 2001 before declining to Rs. 72.24
billion at end-FY2002. During FY2003, CP outstanding peaked at Rs.
95.49 billion by end-September 2002, before declining to Rs. 57.49 billion
by end-March 2003, reflecting a fall in primary issuances by corporates
having access to sub- PLR lending. During FY2004, CP issuances picked
up since November 2003 and reached a peak of Rs. 95.62 billion at end-
January 2004. Although CP has emerged as an important source of funding
WC needs; it is restricted to a few large companies with triple-A corporate
ratings and does not enjoy wider market acceptability. Thus, bank credit in
the form of CC and WC demand loans continues to remain the principal
source of WC requirements.
• The net resources raised by MFs, which had increased from Rs. 8.92 billion
in FY1986 to Rs. 130.21 billion in FY1993, turned negative to Rs. 58.33
billion in FY1996, before increasing to a record Rs. 221.16 billion in
FY2000. However, net resources raised by MFs declined from FY2001-03.
Net resources raised by MFs increased sharply from Rs. 41.96 billion
during FY2003 to Rs. 468.08 billion during FY2004. By comparison,
aggregate deposits of SCBs increased Rs. 2,212.91 billion during FY2004,
as compared with Rs. 1,805.73 billion during FY2003.
• NBFCs shot into prominence during the early 1990s, with their deposits
increasing from Rs. 172.36 billion in FY1991 to Rs. 1,243.69 billion
during FY1997. However, following changes in the regulatory
framework, the public deposits of NBFCs/RNBCs have declined
significantly to Rs. 188.22 billion at end-FY2002. In the immediate
post-reforms years (1992-93 to 1996-97), banks did lose out to NBFCs,
new public issues, and MFs. NBFCs took advantage of the softer
regulatory treatment to expand rapidly and provide credit to new areas,
but subsequently suffered from maturity mismatches and withdrawals
after the collapse of a prominent corporation. Similarly, the Indian stock
market, which enjoyed a boom and a massive increase in initial public
offerings (IPOs), was in the doldrums during FY2001-03 for a variety
of reasons. As a result, the capital markets remained subdued. While the
resource mobilisation from the public issues market declined, that from
the private placement market witnessed a lower growth. Resource
mobilisation by MFs also declined sharply during FY2001-03.
Notwithstanding financial innovations, bank deposits continue to be the
most important instrument of financial saving among the households. In
fact, the share of bank deposits in household financial savings has
increased over the last decade. The share of insurance funds, provident
and pension funds has also increased. The proportion of household
financial savings in shares and debentures, including investments in
mutual funds, increased steeply during the early-1990s—from 11.6%
during FY1987-FY1991 to 17.1% during FY1992- FY1996. However,
this was due to a shift away from the relatively safer modes of saving,
such as small saving instruments, than from bank deposits. Following
the irregularities in stock market in 1992 and the associated price
uncertainty that prevailed in the subsequent period, the proportion of
household financial saving in shares and debentures declined. The
 pattern of household financial savings emerging after a decade of
reforms, indicates a continued preference of households for relatively
safer instruments (bank deposits, insurance, provident and pension
funds, and small savings).
Composition of Gross Financial Assets of the Household Sector
(percent)

As the preceding analysis indicates, the disintermediation process has received a

setback during the last few years, with a decline in public deposit mobilisation by
NBFCs, a poor performance of the capital markets, and a sharp decline in new
capital issues by nongovernment public limited companies. Banks continue to
remain 'special' in the financial system as the primary financial intermediary,
especially in view of the wide branch network.

DOMESTIC TRENDS

Mergers
As in the global industry, the Indian banking sector has been witnessing a spate of
mergers. While the Times Bank merged with HDFC Bank during FY2000, ICICI
Bank merged with Bank of Madura during FY2001. Through its merger with ICICI
Ltd. in 2002, ICICI Bank has become the second largest SCB in India. During
FY2003, while Benares State Bank Limited merged with BoB, Nedungadi Bank
merged with PNB. Apart from the possible benefits of scale economies through
mergers, SCBs also expect to exploit revenue scope and product mix economies by
cross-selling different types of financial services. With the entry of some banks
into the insurance sector, customers may be willing to pay more for the
convenience of one-stop shopping for their commercial banking and insurance
needs. Similarly, a corporate customer may prefer to reveal its private information
to a single consolidated entity that provides its commercial and investment banking
needs. Revenue economies can also arise from sharing the reputation that is
associated with a brand name that customers recognize and prefer. The trend
towards universal banking may also result in cost savings through sharing physical
inputs like offices or computer hardware; utilizing common information systems,
account service centers; raising capital in larger issue sizes that reduce the impact
of fixed costs; or reusing managerial expertise or information. A consolidated
commercial bank and insurer may lower total costs by cross-selling, using each
other's customer database at a lower cost than building and maintaining two
databases. Similarly, information reusability may reduce costs when a universal
bank acting as an underwriter conducts due diligence on a customer with whom it
has had a lending or other relationship.

The concept of mergers is not new for India’s PSBs. It has been on the reforms
agenda since 1991, when the Narasimham Committee chalked out a blueprint for
banking sector reforms. However, at that time, the merger spree had not gathered
much steam. Earlier, mergers usually occurred in India only when banks
encountered difficulties. For instance, as fallout of the 1992 securities scandal in
Mumbai, the Bank of Karad failed. Offers were invited from all PSBs for
purchasing specified assets of the bank, taking overall demand and time liabilities
and offering employment to all members of staff. Bank of India was the only bank
to make an offer, which was finally accepted in mid-1994. In the case of New Bank
of India, it had been incurring losses for four consecutive years, and finally, it
reached the point where the cumulative losses and a shortfall in provisions eroded
its capital and reserves. The bank was merged with Punjab National Bank in
September 1993, the first occasion that a merger of two PSBs had been undertaken.
However, this bail-out merger did not fare well and Punjab National Bank which
had a track record of being a profitable bank till then, posted net losses in FY1994
as a direct result of the merger.
Mergers and acquisitions remain one of the best options by which banks can grow,
consolidate, achieve scale economies and acquire new markets. However, while
consolidation may help in attaining scale economies, it should be remembered that
it does not solve some basic problems of Indian banking. Mergers and acquisitions
are no panacea for poor asset quality, poor management, indifference to technology
upgradation and lack of functional autonomy and operational flexibility. In the
context of the Indian banking sector, the scope of mergers is also constrained by
the public ownership of banks, and would depend on the RBI and the
Government’s views on the desirability of mergers.
Consumer Banking
Indian SCBs have always had a relationship with retail customers on the funding
side, i.e. retail deposits. However, till now, on the asset side, the focus had been on
corporates. Home loans, credit cards and other forms of personal lending have now
emerged as one of the fastest growing areas in the financial services industry. This
trend has to be seen in the context of the growing income of the Indian middle
class and the significant change in attitude towards credit. The traditional aversion
to debt is now receding and purchases are increasingly financed by credit rather
than savings. While corporate banking is strongly linked to economic cycles,
consumer finance provides a more stable source of earnings. However, the skills
required for retail banking are quite different from corporate banking. Success in
retail banking requires high levels of customer service, modern technology and
motivated sales staff. While PSBs, by virtue of their distribution strength, have
access to a large base of customers in the hinterland, they are hampered by the lack
of operational autonomy, low level of technology and lack of incentive based
compensation for employees.
Internet Banking
Just as the use of ATMs has not replaced branch banking, so would not Internet
banking. Internet banking is a relatively new front-office technology. Some banks
offer a variety of levels of Internet service and combinations of Internet and
physical offices and ATM networks. Some banks employ a `click and mortar’
implementation strategy in which the banks add a transactional Internet site to their
physical offices and ATM networks. A transactional site allows customers to make
 transactions on-line such as accessing accounts, transferring funds, applying for a
loan, etc. Other banks have set up informational websites that provide information
about the banks and their services, but do not allow for on-line transactions.
However, many banks continue to offer no Internet services. Internet banking is the
cheapest of all banking channels and helps banks cut transaction costs by a
substantial amount. Success in this area would depend on the quality of technology
and early entry into this area. However, the main concern in online banking is the
security of Internet transactions. These concerns may be alleviated in the coming
years with the use of electronic signatures. Banks would have to adapt to Internet
banking in various degrees to avoid becoming obsolete. In the long term, because
of intense competition the margins are likely to come under pressure. This is
because once the client is on the Net, he/she is only a mouseclick away from other
competitors. Further, as the costs are much lower for Internet-based transactions,
the barriers to entry are lower as well. Sustainability is going to be a major
challenge for banks going online. The survival strategies might vary depending on
the strengths and operational profiles of banks, and on their ability to identify niche
markets where they have core competencies.

ANNEXURE: KEY INDICATORS OF INDIAN SCBS

(Rs. billion)
I